Bank regulators dynamited our today.

In Washington Post’s Obituaries of May 18, Brian Murphy quotes Kemal Dervis, as Turkey’s minister of economic affairs in 2001 with: “We all should tighten our belts. Don’t expect me to produce policies to save us just for today. We can’t dynamite our future in order to save today.” 

Sadly, that is exactly what bank regulators, with their risk weighted bank capital/equity requirements, have been doing for the last decades.

Favoring so much easy-credit, refinancing a perceived safer present, over harder-credit, financing a more uncertain riskier future; like Treasuries and residential mortgages over e.g., loans to small businesses and entrepreneurs, has landed us precisely where we find ourselves. 

I don’t think I have to detail where that is. Just open any newspaper to read about that. E.g., the debt ceiling

November 2015 published a letter in which I argued about a “de facto reverse mortgage on the economy, which extracted the value it already contained, as banks focused more on refinancing the safer past than the riskier future.”

ChatGPT - OpenAI: Could the risk-free interest rate or the natural rate be affected by credit risk weighted bank capital requirements?

I asked OpenAI

"Could the risk-free interest rate be affected by credit risk weighted bank capital/equity requirements?"

OpenAI answered:

"Yes, the risk-free interest rate can be indirectly influenced by credit risk-weighted bank capital/equity requirements. Here's how it can happen:

1. Monetary Policy and Interest Rates: Central banks use various tools, including setting the risk-free interest rate, to implement monetary policy and manage economic conditions. If banks are subject to stricter capital requirements, it may impact their ability to lend and the overall stability of the financial system. In response, central banks may adjust their monetary policy, including the risk-free interest rate, to mitigate any adverse effects on lending and economic activity.

2. Market Perception and Risk Premium: Credit risk-weighted capital requirements reflect the perceived riskiness of a bank's assets. If banks are required to hold more capital due to higher credit risk, it indicates that the underlying assets are considered riskier. This perception of increased risk can influence market participants' behavior and increase the risk premium demanded for lending or investing, including the risk-free rate.

3. Systemic Risk and Default Risk: Credit risk-weighted capital requirements aim to reduce the likelihood and impact of bank failures. By enforcing stricter capital requirements, regulators mitigate the systemic risk posed by banks and enhance their resilience to financial shocks. A more stable banking sector with lower default risk can contribute to overall financial stability, which, in turn, can affect the perceived risk-free interest rate.

It's important to note that the relationship between credit risk-weighted capital requirements and the risk-free interest rate is complex and can be influenced by a range of factors, including economic conditions, regulatory policies, and market dynamics. Additionally, while there may be indirect effects, the risk-free interest rate is primarily determined by broader market forces and central bank monetary policy decisions."

Comment: https://subprimeregulations.blogspot.com/2013/01/the-subsidized-risk-free-rate.html

I asked OpenAI

"Could the natural interest rate be affected by credit risk weighted bank capital/equity requirements?"

OpenAI answered:

"The natural interest rate, also known as the equilibrium interest rate, is primarily influenced by broader economic factors such as productivity, savings, investment demand, and monetary policy. While credit risk-weighted bank capital/equity requirements can indirectly impact the overall financial system and economic conditions, their effect on the natural interest rate is less direct. Here are a few considerations:

1. Financial Stability: Credit risk-weighted capital requirements are designed to enhance the stability of the banking system by ensuring that banks hold adequate capital to absorb potential losses. By reducing the probability of bank failures and systemic risks, these requirements contribute to overall financial stability. A more stable financial system can have a positive impact on the natural interest rate by supporting investor confidence, reducing uncertainty, and promoting sustainable economic growth.

2. Lending Conditions and Investment Demand: Stricter capital requirements may affect the availability and cost of credit in the economy. If banks are required to hold more capital due to higher credit risk, they may adjust their lending practices, which can impact investment demand. This, in turn, can have indirect effects on the natural interest rate as investment decisions are influenced by the cost and availability of financing.

3. Monetary Policy Transmission: Credit risk-weighted capital requirements can influence the effectiveness of monetary policy transmission. If banks face higher capital requirements, it may affect their ability to transmit changes in monetary policy to borrowing costs in the broader economy. This could potentially impact the natural interest rate indirectly by affecting the overall effectiveness of monetary policy in stimulating or moderating economic activity.

While credit risk-weighted bank capital/equity requirements can have some influence on the natural interest rate, their effects are part of a complex web of interrelated factors. It's essential to consider that the natural interest rate is driven by a broader range of economic factors, such as productivity growth, demographics, and fiscal policy, along with monetary policy considerations."

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

PS. 2013 on the same theme: "The subsidized risk-free rate."

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

ChatGPT - OpenAI: As a small business, is my access to bank credit made harder by the risk weighted bank capital requirements?

I asked OpenAI:

 

"If banks are required to hold much more equity against loans to small businesses than against Treasuries and residential mortgages, as a small business, is my access to bank credit made harder than it would be in the absence of such regulation?"

OpenAI answered:

"Yes, if banks are required to hold more equity against loans to small businesses compared to other assets such as Treasuries and residential mortgages, it can potentially make your access to bank credit harder as a small business.

The regulation you mentioned is typically based on risk-weighted capital requirements, which are imposed by regulatory authorities to ensure the stability and safety of the banking system. These requirements aim to mitigate the risks associated with different types of assets held by banks.

When banks are required to hold more equity (capital) against loans to small businesses, it increases the risk-weighted capital requirement for such loans. As a result, banks may become more cautious and conservative when lending to small businesses, as it becomes relatively more expensive for them to hold the required capital against these loans. This could potentially lead to tighter lending standards, higher interest rates, or reduced credit availability for small businesses.

The intention behind these regulations is to protect the banking system from excessive risk-taking and to ensure that banks maintain adequate capital buffers to absorb potential losses. However, it can have unintended consequences, such as making it harder for small businesses to access bank credit, as banks may prioritize other assets with lower capital requirements.

It's important to note that the impact of these regulations can vary depending on various factors, including the specific regulatory framework in your country, the size and stability of the banking sector, and the overall economic conditions. Additionally, alternative sources of financing, such as non-bank lenders or government-backed loan programs, may exist to support small businesses in accessing credit."

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

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

ChatGPT - OpenAI: Allowing lower bank equity requirements against what’s perceived safe than against what’s perceived risky, could that distort the allocation of bank credit?

I asked OpenAI:

"When lending banks take into account what they perceive as safe and as risky. If regulators allow lower bank equity requirements against what’s perceived safe than against what’s perceived risky, could that distort the allocation of bank credit?"

OpenAI answered:

"Yes, if regulators allow lower bank equity requirements against what is perceived as safe than against what is perceived as risky, it could distort the allocation of bank credit. Banks have an incentive to allocate more credit to what is perceived as safe, even if it is not the most economically productive use of that credit, in order to take advantage of the lower equity requirements.

This could lead to a misallocation of credit, as potentially more productive or riskier investments may not receive the necessary funding. Moreover, it could lead to an overconcentration of credit in certain areas, which could create systemic risks in the banking system.

To mitigate these risks, bank regulators should ensure that equity requirements are appropriately set based on the risk of the underlying assets. This would help ensure that banks allocate credit based on economic merit rather than regulatory arbitrage, which is essential for a healthy and stable banking system."

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

PS. I’ve been arguing for decades against bank regulations based on that what’s perceived as risky being more dangerous to our bank systems than what’s perceived as safe. For instance, 2012, Financial Time’s chief economics commentator Martin Wolf gave a testimony to that effect.

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