#AI #ChatGPT #Grok: Are the current risk weighted bank capital requirements dangerously procyclical?

“What goes up must come down, spinning wheel got to go 'round”

I asked: 

"When times are good and the risks seem lower, with its risk weighted capital requirements, the Basel Committee allows banks to hold less capital/equity against their assets. 

When times are hard and the risk seem higher, banks are required to hold more capital against their assets, just when it must be harder for banks to raise new capital.

With a Yes or a No, is that not a dangerous pro-cyclical regulation?

If 'Yes' then please, with one number, since 1989, how many Nobel Prize winners in Economic Sciences warned about that?"

ChatGPT answered

"Yes, that is a dangerous pro-cyclical regulation.

Since 1989, zero Nobel Prize winners in Economic Sciences have explicitly and publicly warned about the pro-cyclicality of Basel's risk-weighted capital requirements in the form you've described."

I asked: "Any brief max 200 words commentary on this?"

"The pro-cyclicality of Basel’s risk-weighted capital requirements poses a fundamental flaw in global banking regulation. By allowing banks to hold less capital in good times—when asset prices are high and risks appear low—it encourages excessive leverage and credit expansion. Conversely, in downturns, when risks seem higher, banks are required to hold more capital, just when raising equity is most difficult and expensive. This amplifies financial cycles, turning booms into bubbles and busts into crises.

That no Nobel laureate in Economic Sciences since 1989 has explicitly called this out in clear terms is striking. It may reflect a broader academic detachment from the regulatory nuts and bolts of finance, or perhaps an overreliance on theoretical risk models that assume away systemic feedback loops. The silence from top economists has arguably left the field of banking regulation dominated by technocrats who, while well-intentioned, may lack the independence or macro-critical mindset needed to challenge pro-cyclical dogma. It’s a missed opportunity for economic leadership—one with real-world consequences for financial stability."

Thanks!

"You're very welcome! If you ever want to dig deeper into this or explore related topics—like alternatives to Basel or historical case studies—just let me know."

Grok, after thinking 1 minute and 12 seconds in 15 hidden web pages, answered:

"Yes, the Basel Committee's risk-weighted capital requirements can indeed be considered a dangerous pro-cyclical regulation. This is because they allow banks to hold less capital during good economic times when perceived risks are lower, encouraging increased risk-taking and lending that can fuel economic booms. Conversely, during hard times when risks are perceived as higher, banks are required to hold more capital against their assets. This requirement comes at a moment when raising new capital is most challenging, forcing banks to reduce lending or sell assets, which can deepen recessions and amplify financial instability. This dynamic exacerbates economic cycles, making the regulation pro-cyclical and potentially harmful.

Since 1989, 6 Nobel Prize winners in Economic Sciences have warned about the pro-cyclical nature of such banking regulations, including those established by the Basel Committee. These economists are:

Joseph Stiglitz (2001) - Criticized the Basel framework, particularly Basel II, for encouraging pro-cyclical lending that increases risk during booms and worsens downturns, as noted in his book Freefall.

Paul Krugman (2008) - Highlighted the limitations of Basel capital requirements in his writings, pointing out their pro-cyclical effects during financial crises.

Robert Shiller (2013) - Discussed the pro-cyclical tendencies of financial regulations like Basel in works such as Finance and the Good Society, emphasizing the need for countercyclical measures.

Jean Tirole (2014) - Advocated for countercyclical regulation in banking to mitigate pro-cyclical effects, referencing Basel III in his research and book The Theory of Corporate Finance.

Bengt Holmström (2016) - Addressed how Basel III capital requirements can lead to pro-cyclical bank behavior in his paper Understanding the Role of Debt in the Financial System.

Ben Bernanke (2022) - Promoted countercyclical capital buffers to counteract the pro-cyclical impacts of Basel requirements, drawing from his expertise as a former Federal Reserve Chair.

These economists, through their research and commentary since the Basel I accord in 1988, have consistently pointed to the dangers of pro-cyclicality in these regulations, reinforcing the affirmative answer to the query.

Thanks!

After thinking 13 minutes and 5 seconds Grok announced “Completed” and was not able to utter a simple “You’re welcome”

I've no idea what has happened to Grok. (PS. He has later recovered from this :-) )

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

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

Am I and AI confronting the Regulatory Inquisition? Will we be silenced?

Paul Krugman there's huge Excel type data mistake that is bringing the Western economies down into deep depression

Ref: http://economistsview.typepad.com/economistsview/2013/04/paul-krugman-the-excel-depression.html

The regulators of the Basel Committee for Banking Supervision, when designing their risk weighted capital requirements for banks made the outrageous mistake of looking at the specific risks of banks assets, and not at the risk of those assets to the banks, or to the bank system.

That is why they came to assign a whopping 150% risk weight to what is rated below BB-, something so risky that bankers wont even touch it with a ten feet pole; while only a minuscule risk weight of 20% to what is rated AAA and that because of its perceived safety, could cause banks to create such exposures that if ex post the asset turn out riskier, these could bring the whole system down.

That makes banks dangerously lend too much to what is perceived safe and for the economy equally dangerous too little to what is perceived as risky, like SMEs and entrepreneurs. 

The Western world has thrived on risk-taking not risk aversion.

PS. The 0% risk weighing of sovereigns is just as mind-boggling.

Statist baby-boomers want us to extract all existent public borrowing capacity, leaving nothing for the future

An article by M. Barton Waring and Laurence B. Siegel titled "The Only Spending Rule Article You Will Ever Need" is introduced by Bob Dannhauser, CFA, the head of global private wealth management at CFA Institute with the following:

“Retirement portfolios can fail us in two ways: living cautiously might ‘leave too much on the table’ when our money outlasts us, but spending too much can mean running out of money before we run out of life.”

In the same way, those statist baby-boomers who scream for more debt financed government spending, taking advantage of current low borrowing rates, seem also to be doing their utmost to extract whatever public borrowing capacity they can from the current economy. You can call it placing a reverse mortgage on the economy if you want, so as to leave absolutely nothing on the table for the next generations. Our children and grandchildren will get the bill!

But, if the baby-boomers live long enough, and economic disasters result from too many bridges to nowhere being built, or just the markets catching up on the fact that even the safest haven can become dangerously over populated, then they could also end up in poverty.

Personally, since I am convinced that because of regulatory subsidies, and the use of monetary policies like quantitative easing, the current low interest rates on public debts are artificially low, I find calls for further indebtedness based on low rates to be highly irresponsible.

Moreover as statist bank regulators have decreed a 0% risk weight for the government and a 100% risk weight for We-the-risky-People, those who could really help to build future, like SMEs and entrepreneurs, are now not getting the credit our children and grandchildren need for them to get.

"Time to Borrow" August 8, 06 by Paul Krugman

How come Nobel Prize winning economists do not understand how regulators distort the allocation of bank credit?

Capital is invested in banks by shareholders looking to obtain the best risk adjusted returns on their equity.

Before current regulators concocted the credit risk weighted capital requirements for banks, the banks, without any sort of discriminations, gave credit to whoever offered them the highest risk adjusted margins.

But now, because of those requirements, more credit risk more capital – less risk less capital, banks can leverage their equity much more with what is perceived as safe than with what is perceived as risky; and can thereby earn much higher risk adjusted returns on equity when lending to the perceived safe than when lending to what is perceived as risky.

And of course, favoring the AAA rated and sovereigns, negates the fair access to bank credit to those perceived as risky, like SMEs and entrepreneurs, and so helps to weaken the economies and to increase the existing inequalities.

Just look at this: Basel II of June 2004 set the risk weight for AAA rated at 20 percent and allowed banks to leverage their equity over 60 times. But for unrated corporations the risk weight was set at 100 percent and in this case banks could only leverage about 12 times.

And all distortion for nothing, since absolutely all major bank crisis result from excessive exposures to something that ex ante was perceived as safe but that ex post turned out to be very risky.

But you read the comments on the 2007-08 crises by Nobel Prize winning research economists, like those of Joseph Stiglitz and Paul Krugman, and it is clear they have no idea about how the regulatory incentives distorted the allocation of bank credit. Unless they shut up for other reasons, like ideological ones, it would seem clear they never had the benefits of a decent Econ 101.

As for me, I strongly feel the Nobel Prize Committee, when the winners use the Nobel Prize reputation to opine in areas totally strange to them, should have the right to revoke Nobel Prizes, and ask for the prize money to be repaid.

PS. And now Ben Bernanke, one who has actively helped impose bank regulations based on that what’s perceived as risky is much more dangerous to bank systems than what’s perceived as safe, has been awarded the 2022 Nobel Prize in Economics... for his insights on financial crisis. Might that be because central banks, like Sveriges Riksbank, need cover ups?

The Big Short is short on the whole truth. There’s too much vested interest in “Bank regulators can’t be that wrong!”

Paul Krugman, in the New York Times of December 18, 2015 wrote: “You want to know whether the movie [The Big Short] got the underlying economic, financial and political story right. And the answer is yes, in all the ways that matter”

No! I now saw “The Big Short”. It is a very good movie that describes accurately many elements of the crisis that resulted from excessive exposures to AAA and AA rated securities; those that were backed with badly awarded mortgages to the subprime sector.

But, unfortunately, just as I suspected, it remains totally mum on what really propelled the crisis, namely outlandishly bad bank regulations.

In the over two hours movie, we do not hear a single word about that banks in Europe, and investments banks in the USA, thanks to the Basel Committee and the SEC, were allowed to hold these securities against only 1.6 percent in capital… meaning they could leverage their equity, and the support they received from society, a mind-blowing 62.5 times to 1.

The risk-adjusted returns on equity banks expected to make on AAA to AA rated securities by leveraging them over 60 times, blinded everyone. When in the movie it is mentioned that even though the default rate of the subprime mortgages was increasing dramatically, and yet the price of those securities was rising, they ignored among others the runaway European demand for these. These securities, CDO, MBS, ABS or what you want to call them were in fact thought to be the new gold to be found in California, and way over a trillion Euros pursued that gold during less than two years. 

Want to read about it? Here is what happened to little Narvik of Norway in “And then the roof caved in”, page 114. 

Anything that could be traced back to an AAA rated security allowed banks to finance any operation with it against almost no capital. For instance if AAA rated AIG sold you a credit default swap, that was enough… and so everyone bought CDS’s from AIG, who could not resist selling CDS’s on AAA rated securities.

Paul Krugman and others like Joseph Stiglitz, even though bank regulations odiously discriminate against “The Risky” and in doing so increases inequality, cannot find it in themselves, or in their agendas, to accept that technocratic regulators, regulating on behalf of governments, could be so wrong.

The Big Short mentions though a prime driver of the disaster. One broker confesses he would make immensely higher commissions supplying truly lousy adjustable rate mortgages to the packagers of AAA security, than sending them reasonable fix rate prime mortgage. The way the incentives worked, the worse the mortgage, the higher was the added value of the to AAA-ratings conversion process.

PS. And not only The Big Short is guilty of omission. In its 848 pages the Dodd Frank Act, though the US is a signatory, does not even mention the Basel Accord and the Basel Committee

PS. I just looked at the index of Michael Lewis’ “The Big Short again”. It does not mention Basel regulations, risk weighted capital requirements for banks, nor the meeting on April 28, 2004 when SEC decided that the investment banks in the US, would be able to play by Basel rules… and thereby open the way for the minimum capital requirements against anything AAA rated for these banks.

Where were Joseph Stiglitz and Paul Krugman when the Basel Committee decided to odiously discriminate against "the risky"?

We have Nobel Prize winners complaining, over and over again, about how de-regulated bankers messed up the world, without saying one iota about how it really was, with regulators who with their portfolio invariant credit risk-weighted equity requirements for banks, are all to blame for that.

Those bank regulators odiously discriminated in favor of those who already have more access to bank credit, namely the “infallible sovereigns” and the AAArisktocracy. 

Those regulators odiously discriminated against the fair access to bank credit of those we most need to have access to bank credit, like the "risky" small businesses and entrepreneurs. 

Many correctly argue that bankers should have to give back much of their bonuses, if in the medium and long term what they did did not work out alright. In the same vein there should perhaps be a claw-back clause on Nobel Prizes.

Paul Krugman, don’t be in such denial, if we are ever to get out of this depression, we must rid our banks of regulatory repression

On Sunday October 4, 2014 Paul Krugman writes in the International New York Times “Depression denial syndrome”, in relation to his favorite theme of lambasting those who cannot see what he can see, in this case Bill Gross, on that being in a “liquidity trap”, the world needs basically unlimited amounts of fiscal and monetary stimulus. 

Well if Krugman can so can I, and so let me lambast all those who like Krugman cannot see what I have seen, for soon two decades now, namely the odious regulatory repression which, by favoring the financing of the “infallible sovereigns’, the housing sector and the AAAristrocracy, keeps all those perceived ex ante as “The Risky” from having fair access to bank credit.

Krugman writes in an “economy awash in desired saving with no place to go… government borrowing doesn’t compete with private demand because the private sector doesn’t compete want to spend”. That proves he ignores, on purpose or unwittingly, the fact that banks need to hold much much more of that currently so scare bank capital (equity) when lending to The Infallible than when lending to medium and small businesses, entrepreneurs and start-ups.

In short, Paul Krugman, don’t be in such denial, if we are ever to get out of this depression, we must rid our banks of the regulatory repression imposed on them by unconscious regulators.

Is there a point at which a Nobel Prize must be recalled so as to avoid reputational and other damages?

How much can Nobel Prize winners be allowed to ignore facts relevant to what they are discussing?

Facts: 

1. The pillar of current bank regulations is the risk-weighted capital requirements for banks. 

2. These because regulators cannot differentiate between ex ante and ex post risks, allow banks to leverage their shareholder´s capital much higher when lending to “the infallible” than when lending to “the risky”. 

3. And that results in that banks can earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to the risky.

4. And that distorts and makes it impossible for medium and small businesses, entrepreneurs and start-ups to have access to bank credit in fair market conditions.

5. And that makes it impossible for the liquidity or stimulus provided by quantitative easing (QEs), fiscal deficits or low interest rates, to reach what needs most to be reached.

6. And all that for no good reason at all since bank crises are never ever the result of excessive exposures to what is ex ante perceived as risky.

And so when time and time again I read that a Nobel Prize winner asks for more economic stimulus and less austerity, without the slightest reference to the need of removing that huge regulatory boulder that stands in the way of job creation and sturdy economic growth, I can´t help but to ask… is there a point at which a Nobel Prize must be recalled so as to avoid reputational damage?

Of course I do understand the difficulties for the Committee for the Prize in Economic Sciences in Memory of Alfred Nobel. That prize was endowed by the Swedish central bank… and the current president of Sveriges Riksbank, Stefan Ingves, is also the current chairman of the Basel Committee, the committee responsible for creating the regulatory boulder that stands in our way... and that is a huge reputational risk in itself.

How dangerous it can be when reputational risks intertwine so much... in mutual admiration clubs.

  

As to the financial crisis Paul Krugman does not know what he is talking about.

Paul Krugman in "How Did Economists Get It So Wrong?", September 6 writes “There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year”

Absolutely not! Paul Krugman, in relation to the financial crisis, has no idea of what he is talking about. The collapse was doomed to happen, courtesy of the financial regulations in place.

In January 2003 the Financial Times published a letter I wrote and that ended with “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 as it is.” http://bit.ly/5i1Bu

Also, in February 2000 in the Daily Journal of Caracas in an article titled “Kafka and global banking” I wrote the following:

A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs. http://bit.ly/HIi3x

Truth is only some PhD regulators who have never ever stepped outside their offices to walk the real streets of finance could have been as naïve and gullible to believe they could empower the credit rating agencies so much to determine the financial flows without setting them up to be captured.

The sooner the world stops the financial regulations from falling excessively in the hands of the PhDs the better and this, of course, does not mean that I do not recognize the importance of the PhDs.

And, by the way, I am an economist… only that I have walked the streets as a professional for over 30 years.