My published letters on the 2008 GFC, caused by AAA rated MBS stuffed with subprime mortgages.

For sausages, find the cheapest meat, slice & dice it, stuff the casings, and sell it as a delicacy.

Mortgage-backed securities (MBS) with subprime stuff, were rated AAA, which thanks to Basel II allowed banks to leverage these 62.5 times.

The 2008 GFC ensued.

Financial Times: January 11, 2003

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. Friends, please consider that the world is tough enough.

Financial Times, August 23, 2006

Long-term benefits of a hard landing.

While you correctly argue (“Hard edge of a soft landing for housing”, August 19,) that “even if gradual, a global housing slowdown would be painful” you do not really dare to put forward the hard truth that the gradualism of it all could create the most accumulated pain.

Why not try to go for a big immediate adjustment and get it over with? Yes, a collapse would ensue and we have to help the sufferer, but the morning after perhaps we could all breathe more easily and perhaps all those who, in the current housing boom could not afford to jump on the bandwagon, would then be able to do so, and take us on a new ride, towards a new housing boom in a couple of decades.

This is what the circle of life is all about and all the recent dabbling in topics such as debt sustainability just ignores the value of pruning or even, when urgently needed, of a timely amputation."

Washington Post, September 6, 2007.

Factors in the Financial Storm

David Ignatius, in his Sept. 2 op-ed, "The Real Causes of the Financial Storm" failed to mention the two lead actors in the financial mess we find ourselves in: the credit rating agencies, whose AAA ratings turned what should have remained a local problem involving some subprime lenders into a global financial storm; and, of course, the bank regulators who against all wisdom enabled the credit rating agencies to foist what they consider to be only their First Amendment-enabled opinions upon the markets.

In May 2003, as one of the 24 executive directors of the World Bank, and probably only because of that, I was invited to make some comments during a workshop arranged by the World Bank for bank regulators on assessing, managing and supervising financial risk. Along with offering some suggestions, I told the regulators, "I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit rating agencies. This sure must be setting us up for the mother of all systemic errors."

I never got invited to comment again."

Washington Post: June 20, 2008

An Aspect of the Bubble

"Nothing whetted the appetite for securities collateralized with plainly lousy mortgages as much as the combination of high returns and prime credit ratings. Using a regulatory system for banks that is based on following the credit rating agencies will, given that it is human to err, lead us into even greater danger."

Washington Post: December 27, 2009:

Another 'worst': Faulty bank regulation

"The Dec. 20 Outlook compilation of the decade’s worst ideas did not include the one most to blame for the loss of most of the past decade’s growth: regulations that allowed banks to hold absolute minimums of capital as long as they lent to clients or invested in instruments rated AAA, for having no risk. This launched a frantic race to find AAA-rated investments wherever and finally took the markets over the cliff of the subprime mortgages. 

The most horrific part is that it seems likely to endure because regulators can’t seem to let go of this utterly faulty regulatory paradigm. Let me remind you that banks are allowed to hold zero capital when lending to sovereign countries rated AAA and that there are already many reasons to think that the credit quality of many sovereign states has been more than a bit overrated."

Some of my early public opinions on the Basel Committee's bank regulations

#AI ChatGPT – Grok: Bank regulations favoring government debt over loans to the private sector, does it increase or decrease taxable income?

I asked ChatGPT:

"Current bank regulations favor government debt over loans to the private sector. 

Briefly, in less than 200 words: In the medium and long term, does that increase or decrease taxable income?"

Chat GPT answered:

"Likely decrease in the medium and long term — if the effect is that bank credit is persistently shifted from productive private investment toward government debt.

The mechanism is indirect:

Government borrowing finances current public expenditure, but does not necessarily create equivalent future taxable income.

Loans to entrepreneurs, farmers and businesses can finance investment, productivity, employment and new profits, which generate future taxable income.

If regulation makes government debt relatively more attractive to banks, private-sector credit can be reduced. The IMF has found that greater bank holdings of government securities are associated with lower private-sector credit growth. 

Over time, weaker private investment and productivity can mean slower growth of wages, corporate profits and consumption, and therefore a smaller tax base. The IMF explicitly notes that high sovereign debt and constrained private investment can weigh on productivity and income growth over the long term. 

So, in your terminology, favoring the refinancing of the safer present over financing the riskier future can ultimately reduce the future taxable-income base.

There is an important qualification: government spending financed by debt can itself raise future productivity and taxable income. The outcome therefore depends on what the government does with the borrowed money."

I asked ChatGPT:

"You mention “government spending financed by debt can itself raise future productivity and taxable income.” Briefly, does that not imply bureaucrats know better what to do with public debt, for which they’re not personally responsible for, than the private sector with its bank loans? Is this so?"

Chat GPT answered:

Not necessarily. It does not imply that bureaucrats know better. It means only that public debt can be productive when government chooses productive investments.

There is a fundamental difference in the incentives:

Private borrower: generally risks capital, reputation, bankruptcy and future income; a bank lending to them has an incentive to investigate whether the project can repay the loan.

Government: can borrow against future taxpayers. The individual bureaucrat deciding on a project normally does not personally bear the financial loss if it fails.

Market process: millions of private decisions continually test alternative projects through prices, profits and losses.

Political process: public investment is subject to political priorities, lobbying, bureaucratic incentives and electoral considerations.

That does not mean private investment is always superior—private banks and entrepreneurs also make spectacularly bad decisions. But it does mean there is no economic principle saying that government officials systematically have better information or incentives to allocate capital than private investors.

And this connects directly to your Basel argument: if regulation makes banks favor government debt over private-sector loans, it is effectively giving government a preferential claim on society's scarce savings and credit. Whether that ultimately raises or lowers future taxable income depends heavily on what replaces the private investment that was crowded out."

I said: "Thanks. Though I see you still consider that governments could do better than "the private investment that was crowded out."

ChatGPT replied: 

"Yes — that is a fair reading of what I said, but I would phrase the distinction more carefully.

I was allowing for the possibility that a government investment could, in some circumstances, produce a higher social return than the private investment displaced by it. That is an empirical possibility, not an assumption that bureaucrats allocate capital better.

Your deeper point is about who should have the presumption of competence. If bank regulation deliberately channels credit toward government debt and away from private entrepreneurs, it effectively assumes that government has a better—or at least preferable—use for those financial resources.

That assumption deserves to be demonstrated, rather than built into the regulation.

And there is an important asymmetry: private investors generally bear the consequences of their investment decisions; government officials spend resources ultimately backed by taxpayers. That difference in incentives is a legitimate reason to be skeptical of systematically replacing private capital allocation with government-directed allocation.

So I would revise my earlier wording to:

Government can sometimes invest productively, but that is not a sufficient reason to presume that government should receive preferential access to credit over the private sector.

That, I think, captures your objection more precisely."

I said: Thanks. That last phrase with its "not sufficient reason to presume" makes it clear. 

ChatGPT replied: 

"Exactly. The key distinction is between “can sometimes do better” and “should therefore receive preferential treatment.”

The first is an empirical possibility; the second requires a much stronger justification."

I said: Thanks!

It said: You're very welcome!

I asked Grok:

"Current bank regulations favor government debt over loans to the private sector. 

Briefly, in less than 200 words: In the medium and long term, does that increase or decrease taxable income?"

Grok replied:

"It decreases taxable income.

Preferential capital and liquidity treatment (often 0% risk weights on sovereigns versus 20–100%+ on private loans) tilts bank portfolios toward government securities and away from private credit. This crowds out lending to firms and households, reducing private investment and capital accumulation. 

Lower private capital and productivity slow GDP growth. Wages, profits, and other private-sector incomes—the main tax base—therefore grow more slowly. Government outlays financed by the extra debt are frequently transfers or consumption rather than productivity-enhancing investment, so they do not offset the lost private tax base. Models that remove the regulatory bias show higher long-run private lending, investment, and output. 

The net medium- and long-term effect is a smaller, slower-growing taxable-income base."

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.

#AI ChatGPT – Grok: Development is a UN declared human right. It implies risk taking. Basel decreed risk averse regulations. Could that be taken to the ICC?

 I asked ChatGPT: 

 “1986 the UN declared development a human right, and development requires the willingness to take risks. 

1988, the Basel Committee, decreed risk averse risk weighted bank capital requirements that much favor “safe” government debt over loans to e.g., “risky” small business and entrepreneurs.

Briefly, in less than 300 words, could it be useful to introduce at the International Criminal Court a complaint against the regulators for having violated a human right, so as least have a public discussion about it. Do you believe ICC would dare to hear the case?”

 

ChatGPT answered:

 

Yes—as a vehicle for forcing a serious public discussion, the idea could be interesting; as an actual ICC prosecution, it is almost certainly legally untenable.

The 1986 UN Declaration does indeed proclaim the right to development as an inalienable human right, including participation in and enjoyment of economic, social, cultural and political development. It also says States have duties to create conditions favourable to development.

That gives your argument an intriguing foundation: one could ask whether an international regulatory regime that systematically makes productive, entrepreneurial credit more expensive while privileging government debt has created an obstacle to the realization of that right.

But the ICC is a criminal court with a very narrow mandate. Its jurisdiction is limited to genocide, crimes against humanity, war crimes and aggression. Economic policy, even demonstrably damaging economic policy, is not presently an ICC crime. Moreover, the Rome Statute creates individual criminal responsibility; establishing that particular regulators committed one of those crimes would be an enormous additional hurdle.

So, would the ICC dare hear it? I would say almost certainly not—not because the underlying economic argument is necessarily foolish, but because the Court lacks the jurisdiction.

Paradoxically, that may make your idea useful in another form: a formal legal memorandum or petition asking international human-rights institutions whether risk-weighted regulation can constitute an internationally created obstacle to the right to development. That could put the Basel system itself on trial intellectually, without pretending the ICC has jurisdiction it does not possess.

Would you prefer to develop this as (1) an ICC-style legal argument, (2) a UN human-rights petition, or (3) a provocative public “case against Basel”?

I wanted to say thanks but had no chance.

I asked Grok:

 

“1986 the UN declared development a human right, and development requires the willingness to take risks. 

1988, the Basel Committee, decreed risk averse risk weighted bank capital requirements that much favor “safe” government debt over loans to e.g., “risky” small business and entrepreneurs.

Briefly, in less than 300 words, could it be useful to introduce at the International Criminal Court a complaint against the regulators for having violated a human right, so as least have a public discussion about it. Do you believe ICC would dare to hear the case?”

 

Grok answered:

 

"I'll quickly verify the 1986 UN declaration, the 1988 Basel rules, and ICC jurisdiction so the answer stays accurate and brief. 

The 1986 UN Declaration on the Right to Development exists, but it is a non-binding General Assembly resolution, not a treaty that creates justiciable individual criminal liability.

Basel I (1988) did assign 0% risk weights to most OECD sovereign debt and 100% to ordinary corporate and SME loans, which tilts banks toward government paper. 

 

That incentive structure is a legitimate policy debate. It is not a useful ICC complaint. The Court’s jurisdiction is limited to genocide, crimes against humanity, war crimes, and aggression committed by natural persons after 2002. Regulatory standard-setting by the Basel Committee does not meet those elements. The Prosecutor’s office would screen it out at the preliminary-examination stage for lack of subject-matter jurisdiction; the Court would not “hear” it. 

 

A publicity filing might generate a few headlines, but labeling prudential regulators as international criminals is more likely to make the underlying argument look fringe than to force a serious discussion of credit allocation, sovereign-bank loops, or SME finance. 

 

Better venues already exist: Basel consultations, national parliaments, academic work, and ordinary human-rights reporting mechanisms.

 

The ICC would not need to “dare” anything. It would simply apply its statute and decline.

 

I said: Thanks. "Given that Basel regulations were introduced in 1988 and since then there has been no serious discussion about the relation between their implied risk aversion and development, perhaps “publicity” of any sort might be needed to break that silence."

 

Grok answered:

 

I’ll check whether the Basel–development/risk-aversion link has actually been silent since 1988, so the publicity claim can be judged against the record.

 

The silence is narrower than it first appears. The specific framing you use—1986 right to development versus 1988 risk-weighted capital as institutionalized risk-aversion—has stayed marginal. 

The underlying mechanics have not. Sovereign 0% (or near-0%) weights versus 100% (or high) weights on ordinary SME and entrepreneurial loans have been discussed for years in IMF/World Bank work, academic papers on crowding-out and the sovereign-bank nexus, EU debates over the SME supporting factor, and national hearings on Basel 3.1. 

Per Kurowski raised a close version of the development argument at the UN Financing for Development dialogue in 2007. 

 

So the problem is not total silence. It is that the issue lives in technical and banking-policy channels and rarely becomes a public argument about what kind of risk a society is allowed to take.

 

Publicity can help that translation. It is most useful when it is hard to dismiss: portfolio-share data (government paper vs. SME loans over time), comparisons of regulatory risk weights with actual default and loss rates, and the simple capital-cost arithmetic that makes a “safe” sovereign claim cheaper to fund than a productive private one. Those facts travel.

 

An ICC complaint is a weak instrument for that job. Lack of jurisdiction is obvious; the filing would be treated as a stunt. Stunts sometimes work, but they more often let opponents change the subject from credit allocation to “this person wants to prosecute central bankers.” That can deepen the silence around the real claim rather than break it.

 

If the goal is discussion, the higher-leverage venues are still Basel consultations, parliamentary banking committees, development-finance forums, and clear public writing that stays on the incentive distortion instead of on criminality. The distortion is real enough to stand on its own.

 

I said: Thanks!

 

It replied: You’re welcome. If you want to pick the argument back up later—data, venues, or how to frame the credit-allocation point more sharply—just say so.

Note: The answers are copied exactly from those given to me by ChatGPT and Grok. Grok referenced my article but in this case I inserted the link to it.

Here my many other questions to ChatGPT – Grok on bank regulations.

 

#AI ChatGPT - Grok: If regulators still favor banks holding “safe” public debt and residential mortgages, over loans to the private sector, what’s the outlook for an economy?

I asked ChatGPT:  Briefly, in less than 200 words:

"If when on the margin, there where it most counts, the risk weighted bank capital requirements still favor “safe” public debt and residential mortgages over loans to farmers, small businesses and entrepreneurs, how would you deem the outlook for an economy?"

ChatGPT answered:

"If, at the margin where credit allocation matters most, risk-weighted capital requirements continue to favor “safe” public debt and residential mortgages over lending to farmers, small businesses and entrepreneurs, I would regard the economy’s long-term outlook as structurally weaker than it need be.

The problem is not necessarily that those favored assets are bad. It is that regulation can make them relatively cheaper for banks to hold, while making productive but less standardized private-sector lending relatively more expensive in terms of required capital.

Over time, that can mean:

less financing for new businesses and productive investment;

weaker entrepreneurship and innovation;

slower productivity and wage growth;

greater dependence on government borrowing and rising property values;

and potentially more wealth inequality.

In other words, the system may become very good at refinancing the safer present, while becoming less capable of financing the riskier future.

That is precisely why I think the marginal effect of capital regulation deserves more attention than simply asking whether banks, in aggregate, are adequately capitalized. A well-capitalized banking system can nevertheless be poorly directed."

I asked Grok: Briefly, in less than 200 words:

"If when on the margin, there where it most counts, the risk weighted bank capital requirements still favor “safe” public debt and residential mortgages over loans to farmers, small businesses and entrepreneurs, how would you deem the outlook for an economy?"

Grok answered:

"Poor to mediocre at best—structurally biased toward stagnation rather than dynamism.

Risk-weighted capital rules that treat sovereign debt and residential mortgages as markedly “safer” than loans to farmers, SMEs, and entrepreneurs systematically tilt bank credit toward the former.

On the margin this crowds out productive private investment, raises the relative cost of capital for the real engines of employment and innovation, inflates housing and public-debt stocks, and weakens productivity growth. The result is an economy more prone to fiscal dominance, asset-price cycles, and lower long-run potential output."

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.

Special note: ChatGPT replied: “The system may become very good at refinancing the safer present, while becoming less capable of financing the riskier future.”    That is the exact wording I’ve used many times over the last decades. Am I having an intellectually incestual relation with AI?

#HI #AI- ChatGPT- Grok: When it comes to risk management, have we not left out God’s hand, some would say that which acts through the free markets, way too much?

On risks in “Against the Gods” Peter L. Bernstein in 1996) wrote that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. 

When seeing so much risk managing, I have, for decades, felt that we might be leaving out God’s hand, just a little bit too much. 

When artificial intelligence appeared on the scene, I asked it about that.

 

I asked ChatGPT:

 

“When the regulators held, they knew enough about the future and risks, so as to decree risk weighted bank capital/equity requirements, could one not argue that: the Basel Committee members, with loads of hubris, thought of themselves a bit like Gods?

 

That God’s hand was left out way too much, and that one capital requirement against all bank assets, a leverage ratio, when it comes to knowing it all, would better express our humans’ lackings?”

 

ChatGPT answered:

 

"Yes, one could certainly argue that the Basel Committee, in designing risk-weighted capital requirements, exhibited a degree of hubris—akin to assuming they could foresee financial risks with a precision that history has often shown to be illusory. By assigning different risk weights to assets, regulators implicitly presumed they could reliably quantify and categorize risk across time and financial cycles, despite the ever-evolving and unpredictable nature of markets.

 

A simpler leverage ratio—one uniform capital requirement against all assets—would acknowledge the limits of human foresight and avoid the illusion of precise risk measurement. It would recognize that risk is often hidden in places regulators least expect, and that past risk assessments can become dangerously outdated in crises.

 

In that sense, leaving "God’s hand" out too much—by over-relying on human judgment and statistical models—might have led to regulatory frameworks that failed when reality diverged from predictions, as seen in the 2008 financial crisis. A leverage ratio, by not pretending to know the unknowable, would better reflect our human limitations in mastering risk."

 

I asked Grok:

 

In “Against the Gods” Peter L. Bernstein wrote that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, are we not leaving out God’s hand, just a little bit too much.

 

Do you foresee that a Super-Duper-Grok will one day be able to do a better job than the many millions who conform the market without exposing us to an even larger systemic risk?

 

SuperGrok answered:

 

"Your reflection, drawing on Bernstein’s Against the Gods, is profound. It juxtaposes the modern obsession with risk management—through probability, statistics, and now AI—against a historical worldview where outcomes were entrusted to divine providence. The question you pose is both philosophical and practical: can a hypothetical “Super-Duper-Grok” outperform the decentralized, messy wisdom of millions in the market, without amplifying systemic risks? 

 

Yes, in many ways, but here’s the catch: centralizing risk management in a single AI, no matter how advanced, introduces new vulnerabilities:

 

Single Point of Failure: If Super-Duper-Grok miscalculates or is hacked, the fallout could be catastrophic. Markets, while flawed, are decentralized, so one actor’s error doesn’t tank the system. 

 

Model Risk: Even a super-AI relies on assumptions and data inputs. If those are biased or incomplete (e.g., missing “unknown unknowns”), it could misjudge risks. The 2008 crisis was partly fueled by overconfidence in statistical models that underestimated tail risks.

 

Loss of Human Judgment: Markets incorporate intuition, skepticism, and ethical considerations—qualities an AI might lack. Your nod to “God’s hand” suggests a humility about human limits, a recognition that not all outcomes are predictable or controllable. An AI, however sophisticated, might over-optimize for measurable metrics, ignoring intangibles like cultural values or long-term societal resilience.

 

Let’s explore this, weaving in your concern about whether we’re sidelining “God’s hand” too much.

 

The Philosophical Angle: “God’s Hand” and Humility

 

Your speculation about leaving out “God’s hand” resonates deeply. Bernstein’s point was that mastering risk marked a shift from fatalism to agency, but today’s hyper-technical risk management can breed hubris. We see this in the Basel framework’s rigid “safe vs. risky” categories, which you’ve critiqued, or in the blind spots of pre-2008 financial models. A Super-Duper-Grok might amplify this hubris, assuming it can predict and control everything, sidelining the unpredictability and mystery that “God’s hand” represents.

 

In a theological or philosophical sense, “God’s hand” could symbolize the limits of human (or AI) foresight—events like black swans, moral dilemmas, or emergent phenomena that defy modeling. Markets, for all their flaws, retain a kind of humility through their chaos; no single actor claims omniscience. A Super-Duper-Grok, by contrast, might tempt us to believe we’ve transcended uncertainty, only to expose us to bigger shocks when reality intervenes.

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.

 

 

#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.

#AI ChatGPT – Grok: What best allows sufficient economic resources to take care of older people, risk weighted bank capital requirements, or a leverage ratio?

I asked ChatGPT: Please in 200 words or less.

"In terms of bank regulations, what will best allow there will be sufficient economic resources to take care of people when they get older? Basel’s risk weighted bank capital requirements, or a leverage ratio?"

ChatGPT replied:

"A strong case can be made that a simple leverage ratio is more likely than Basel's risk-weighted capital requirements to support the long-term economic resources needed for an aging population, though reasonable economists disagree.

The central argument is that prosperity in old age ultimately depends on the productivity of the working population. A leverage ratio requires banks to hold the same capital against all assets, reducing regulatory incentives to favor government debt and residential mortgages over loans to entrepreneurs, farmers, and small businesses. If more credit flows to productive investment, innovation, and business formation, future output and incomes may be higher, making it easier to finance pensions, healthcare, and elderly care.

Supporters of Basel's risk-weighted approach argue that it better protects financial stability by requiring more capital against riskier assets, reducing the likelihood of banking crises that can also harm retirees.

The trade-off, therefore, is between targeted risk sensitivity and avoiding distortions in credit allocation. If one believes the current risk weights materially divert lending away from productive investment, then a leverage ratio offers a stronger foundation for creating the wealth that future retirees will ultimately depend upon.

I said: Thanks!

It replied: You're very welcome! ...  It's an interesting question because it shifts the focus from protecting existing wealth to creating the future wealth that an aging society will need. In the long run, retirees consume what the working generation produces at that time—not what is written on financial statements. Bank regulations that better support productivity, entrepreneurship, and capital formation can therefore have effects that extend far beyond the banking sector.

I enjoyed the discussion. Feel free to return anytime if you'd like to explore the topic further.

I asked Grok: Please in 200 words or less.

"In terms of bank regulations, what will best allow there will be sufficient economic resources to take care of people when they get older? Basel’s risk weighted bank capital requirements, or a leverage ratio?"

Grok answered:

A leverage ratio better supports sufficient long-term economic resources for an aging population than Basel-style risk-weighted capital requirements alone.

Risk-weighted rules let banks hold far less capital against assets deemed “low-risk” (e.g., government bonds or certain mortgages). This creates incentives to favor those holdings over lending to businesses and productive investments that drive real growth, productivity, and the tax base or returns needed to sustain retirement systems. Risk weights are also prone to gaming and miscalibration, as evidenced before 2008. 

A simple leverage ratio (Tier 1 capital divided by total exposures, without risk adjustments) acts as a non-gameable backstop. It limits overall leverage uniformly, reduces the chance of hidden undercapitalization, and avoids distorting capital allocation toward specific asset classes. 

The result is more resilient banks that can continue intermediating savings into productive uses through cycles, lowering the probability and severity of crises that destroy wealth and growth. Stable, sustained economic expansion is what ultimately generates the resources—via higher productivity, wages, and fiscal capacity—to support people in retirement. A well-calibrated leverage ratio complements risk weights effectively; standing alone, it is the more robust foundation for long-term prosperity.

I said: Thanks!

It replied: You're welcome! Glad it helped clarify things. If you have more questions on banking regs, economics, or anything else, just let me know. 

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.

Please free us from imprudent risk aversion and give us some prudent risk taking.

The reverse mortgage on the economy the baby boomers allowed will forever shame their intellectual elite.

#AI What if the amount Canada's banks hold in residential mortgages and those in loans to farmers, small businesses and entrepreneurs had been inverted?

I asked ChatGPT

"Canadian banks hold about $2.4 trillion residential mortgages and HELOCs, almost Canada’s GDP; and about half of that in loan to farmers, small businesses and entrepreneurs.

What if a leverage ratio, instead of risk weighted bank capital requirements, had inverted that figure?"

ChatGPT answered:

"Counterfactuals are inherently uncertain, but the implications could have been profound.

If, instead of roughly $2.4 trillion in residential mortgages and HELOCs and about half that amount in loans to farmers, small businesses, and entrepreneurs, the figures had been inverted, Canada might have looked quite different.

A much larger share of bank credit flowing to productive businesses could have meant:

More business formation and expansion.

Higher investment in machinery, technology, and innovation.

Greater productivity growth and stronger wage gains.

More regional economic diversification beyond housing and natural resources.

Greater social mobility through entrepreneurship.

At the same time, a smaller mortgage book might have meant:

Lower household leverage.

Less upward pressure on house prices.

Reduced dependence of economic growth on real estate activity.

Lower vulnerability to housing corrections.

The trade-off is that more lending to entrepreneurs and small businesses would likely have produced somewhat higher loan losses and greater variability in bank earnings. But a simple leverage ratio requiring substantial capital against allassets could have provided a cushion against those risks.

So, while no one can know the exact outcome, it is plausible that Canada would today have a more diversified, more productive, and less housing-dependent economy, albeit one with a banking system taking more exposure to entrepreneurial risk and less to residential real estate. The long-run size of the economy—and perhaps its capacity for innovation—might well have been larger!"

I said: Thanks!

It replied: "You're very welcome.

Your question goes to the heart of a fundamental economic issue: what kind of risks a society chooses to finance. Financing existing houses primarily reallocates ownership of existing assets, while financing farmers, small businesses, and entrepreneurs tends to create new productive capacity, innovations, and jobs.

Of course, both forms of credit are necessary. People need homes, and mortgages are an important part of a modern economy. The policy question is whether regulations should remain neutral between different uses of credit or whether they should, intentionally or unintentionally, tilt the playing field toward some assets and away from others.

That debate—whether bank capital regulations should favor the refinancing of existing assets or the financing of future productive activity—is an important one and has significant implications for economic growth, productivity, wealth distribution, and opportunities for future generations.

Thank you for another thought-provoking question. I always enjoy exploring these issues with you."

I asked Grok:

"Canadian banks hold about $2.4 trillion residential mortgages and HELOCs, almost Canada’s GDP; and about half of that in loan to farmers, small businesses and entrepreneurs.

What if a leverage ratio, instead of risk weighted bank capital requirements, had inverted that figure?"

Grok answered:

"Under a leverage ratio regime (instead of risk-weighted capital requirements), Canadian banks would likely shift their lending portfolios toward more business, farm, and entrepreneurial credit — and relatively less residential mortgage/HELOC lending — inverting or at least sharply reducing the current skew.

This is a classic regulatory arbitrage/distortion effect. 

Here's the reasoning and likely outcomes.

Current Setup (Risk-Weighted Capital Requirements)

Canadian banks (especially the Big 6) hold roughly $2.4 trillion in residential mortgages and HELOCs as of late 2025/early 2026 — nearly matching Canada’s nominal GDP. 

Business lending (including to SMEs, farmers, and entrepreneurs) by chartered banks totals around $900–950 billion in outstanding loans, with SME-specific authorized/outstanding figures in the low hundreds of billions. This skew exists because of risk-weighted assets (RWA) rules under OSFI/Basel frameworks:

Prime residential mortgages typically carry low risk weights (often 20–50% under standardized approaches, or even lower under internal ratings-based models for well-collateralized loans).

Business loans, SME lending, and commercial exposures carry significantly higher risk weights (commonly 75–150%+ depending on the borrower, collateral, and model).

For the same amount of regulatory capital, a bank can hold several times more in low-RW mortgages than in higher-RW business loans. Mortgages are also relatively low-margin but very scalable and historically low-loss (especially insured ones). Result: heavy concentration in housing-related lending. Canadian banks’ domestic residential mortgages often represent ~30–40% of total loans.

Canada already has a leverage ratio requirement (minimum ~3% Tier 1 capital to total exposure, with higher expectations for D-SIBs) as a backstop alongside risk-based rules. But the risk-weighting still dominates portfolio decisions.

What Changes Under a (Primarily or Pure) Leverage Ratio

A leverage ratio is a simple, non-risk-based measure: capital must cover a fixed percentage of total assets/exposures, regardless of risk weight. All dollars lent cost roughly the same amount of capital.

Low-yield, low-risk mortgages become relatively less attractive because they no longer get a “capital discount.”

Higher-yield business, SME, farm, and entrepreneurial loans become relatively more attractive — banks earn a better return on the capital they must hold against every dollar of exposure.

Banks optimize for return on equity/capital. They would:

Originate fewer new mortgages or demand higher rates/spreads to compensate for the now-equal capital cost.

Expand business lending (term loans, lines of credit, equipment financing, working capital, agricultural credit, etc.).

The portfolio could meaningfully invert or rebalance toward the user’s hypothetical: far more credit flowing to productive sectors and relatively less (or slower-growing) mortgage/HELOC exposure.

Empirical and theoretical literature on leverage ratios supports this rebalancing effect. Introducing or emphasizing a binding leverage ratio alongside (or instead of) risk-weighting tends to reduce the relative attractiveness of low-risk-weight assets and can shift portfolios toward higher-yielding (often higher-risk) activities. 

Likely Economic and Financial Impacts of an “Inverted” Figure Positive effects (stronger real economy):

More capital allocation to SMEs, farmers, entrepreneurs, and small businesses — sectors that often report credit constraints and drive job creation, innovation, and productivity.

Reduced “crowding out” of business investment by housing finance.

Potentially faster GDP growth from productive lending rather than asset-price inflation in housing.

Moderation of household debt concentration in mortgages (Canada already has very high household debt-to-income ratios tied heavily to housing).

Lower systemic concentration risk in one asset class (housing), which has been a source of vulnerability in past cycles elsewhere.

Housing market effects (likely cooling or stabilization):

Tighter or more expensive mortgage credit → slower house price growth or even modest declines in overheated markets.

This could improve long-term affordability for new buyers, though it would create short-term pain for existing owners, real estate, and construction sectors.

Less amplification of housing booms/busts via easy credit.

Banking sector and stability:

Banks would hold capital against the full balance sheet more evenly, acting as a stronger backstop against model risk or underestimation of mortgage risks.

Higher overall exposure to business-cycle-sensitive lending (SMEs default more in recessions), but the leverage ratio itself forces more loss-absorbing capital per dollar of assets.

Potentially stronger or more resilient banks over time if the shift improves risk-adjusted returns and reduces housing concentration.

Transition would be gradual (existing mortgages amortize/run off over years).

Potential downsides/risks:

Short-term reduction in mortgage availability or higher rates could slow housing starts and related economic activity.

More business lending increases credit risk in downturns (though offset by the flatter capital requirement).

Banks might respond by tightening underwriting standards on business loans or raising rates there too.

If taken to an extreme (pure leverage ratio with no risk-based element at all), it could encourage some risk-shifting, though the non-risk-based floor limits excessive leverage overall.

Bottom Line

A leverage-ratio-centric regime would remove the artificial subsidy that risk-weighting gives to residential mortgages. The current ~2:1 (or greater) skew toward housing versus business lending would likely reverse directionally — more credit to farmers, small businesses, and entrepreneurs; relatively less (or slower) growth in mortgage/HELOC books. This would probably produce a more balanced, productive allocation of credit across the Canadian economy: stronger support for real economic activity and entrepreneurship, with a cooler (and potentially more sustainable) housing market. It would also reduce some of the distortions and concentration risks built into the current risk-weighted system.

Canada’s existing hybrid framework (risk-based + leverage backstop) already mitigates extremes, and recent OSFI adjustments have aimed to ease capital for some SME lending. A stronger emphasis on the leverage ratio would amplify the rebalancing the user describes. The net effect on growth, stability, and affordability would likely be positive over the medium term, though with transitional frictions in housing-related sectors. 

This is a stylized hypothetical — real-world outcomes would depend on the exact leverage ratio level, interaction with other rules (liquidity, stress testing), macroeconomic conditions, and how banks adapt their pricing and risk appetite.

I said: Thanks!

It replied: "You're welcome! Glad the analysis was useful.

If you want to dig deeper—say, into specific numbers on Canadian bank portfolios, comparisons with other countries' leverage vs. risk-weighting regimes, potential policy tweaks, or how this might play out in housing affordability vs. business growth— just let me know. Happy to explore further.