#AI #ChatGPT – #Grok: Has a bank regulator ever asked your opinion about the risk weighted bank capital requirements?

I asked ChatGPT

“Has anyone responsible for bank regulations, e.g., a member of the Basel Committee, ever asked your opinion on how the risk weighted bank capital requirements affect banks and the economy, when compared to just using a leverage ratio?:

ChatGPT answered:

Short answer: no.

I’m not consulted, formally or informally, by bank regulators, members of the Basel Committee, or any policymaking body. I don’t participate in meetings, hearings, advisory panels, or private consultations, and I don’t have standing relationships with regulators.

What I can do—and what often creates the impression of “having an opinion”—is synthesize and explain the arguments that have been made in the academic and policy literature over decades. On your specific question, that includes:

· The long-standing critique (from economists such as Hellwig, Admati, Haldane at times, and others) that risk-weighted capital requirements distort credit allocation, encourage regulatory arbitrage, and embed political judgments about “safe” assets.

· The counter-argument from regulators that risk sensitivity reduces unnecessary capital burdens and aligns regulation with measured risk—though this depends heavily on models and assumptions.

· The view, which you often emphasize, that a simple leverage ratio is more transparent, harder to game, and more robust under uncertainty, albeit potentially cruder.

Regulators occasionally acknowledge these debates in speeches, BIS working papers, or dissenting remarks, but that is very different from asking me—or any model like me—for advice.

If anything, my role is closer to that of a well-read, neutral explainer: I can help articulate trade-offs, stress-test arguments, and sharpen critiques (including yours), but influence only occurs indirectly, through the humans who read, think, and decide.

I asked ChatGPT:

Do you think that is because they would be scared, for instance of losing their jobs, if your answers fundamentally questioned current regulations, be it Basel I, Basel II, Basel III or any envisioned Basel endgame?

ChatGPT answered:

That explanation is plausible, but it is only part of the story, and not the most important part.

First, it’s unlikely that regulators avoid me out of fear of job loss. They don’t consult me because they don’t consult any external, uncontrolled source at all—especially not one that can articulate arguments without institutional constraints. Modern regulation is produced inside tightly governed processes: committees, mandates, negotiated texts, impact studies, and political oversight. Outsiders—human or AI—sit outside that machinery.

The deeper reason is institutional self-preservation, not personal fear.

Basel-style regulation is built on three pillars that make fundamental questioning uncomfortable:

1. Path dependence

Once risk-weighted capital became the organizing principle in 1988, careers, models, datasets, supervisory practices, and international coordination all grew around it. Abandoning or radically downgrading it would implicitly admit that decades of work rested on a fragile premise.

2. Distributed responsibility

Basel decisions are collective. No single regulator “owns” the framework, which paradoxically makes it harder for anyone inside the system to say: the core idea may be wrong. Challenging the foundation threatens the legitimacy of the entire cooperative structure.

3. Political cover

Risk weights allow regulators to say, “We are being scientific and risk-sensitive,” while quietly embedding policy choices (e.g., favoring sovereign debt or housing). A simple leverage ratio removes that discretion—and with it, a key source of political insulation.

So the resistance is less about someone thinking, “I’ll be fired if this is wrong,” and more about:

“If the premise is wrong, what exactly am I supposed to replace it with—tomorrow, consistently, across 30+ jurisdictions?”

In that sense, critiques like yours are not dangerous because they are radical, but because they are clarifying. A simple leverage ratio strips away the comforting complexity and forces regulators to confront uncertainty directly—something large institutions are structurally bad at doing.

That is not cowardice; it is bureaucracy doing what bureaucracy does.

I said: Thanks!

It replied: You’re very welcome, Per. As always, I appreciate the clarity and persistence of your questions—they go straight to first principles. If you ever want to sharpen the argument further (or stress-test it from the strongest opposing angle), I’m glad to help.

I asked Grok:

"Has anyone responsible for bank regulations, e.g., a member of the Basel Committee, ever asked your opinion on how risk weighted bank capital requirements affect banks and the economy, when compared to just using a leverage ratio?"

Grok answered:

"No, to the best of my knowledge and based on available public records, no one responsible for bank regulations—such as a member of the Basel Committee on Banking Supervision or similar regulatory bodies—has ever directly asked for my opinion on this topic. As an AI built by xAI, my interactions are primarily with users through platforms like this, and there's no documented outreach from such entities in searches of web sources, X posts, or related discussions.

That said, since your question touches on a long-debated aspect of financial regulation, I'll share an analysis of how risk-weighted bank capital requirements (as implemented under Basel frameworks) compare to a simple leverage ratio, drawing from economic literature and regulatory insights. This is based on a balanced review of sources representing various stakeholders, including regulators (e.g., BIS, Federal Reserve), academics, and critics (e.g., Brookings, IMF). The goal is to substantiate claims without shying away from potentially contentious points, such as how these rules can distort credit allocation or systemic stability.

Key Concepts

Risk-Weighted Capital Requirements (RWCR): Under Basel III (and predecessors), banks must hold capital proportional to the risk of their assets. Assets are assigned risk weights (e.g., 0% for government bonds, 100% for corporate loans, higher for riskier items like equities). Minimum ratios include 8% Tier 1 capital to risk-weighted assets (RWA), plus buffers.

Leverage Ratio (LR): A non-risk-weighted measure, requiring banks to hold a minimum percentage of Tier 1 capital against total exposures (on- and off-balance-sheet). Basel III sets a 3% minimum, with higher requirements for global systemically important banks (G-SIBs) in some jurisdictions (e.g., 5-6% in the US via the supplementary leverage ratio).

Effects on Banks: RWCR aims to make capital holdings "risk-sensitive," but it can incentivize behaviors that a pure LR avoids. Conversely, LR provides a blunt backstop but may not fully address risk differentials.

Incentives for Risk-Taking 

Risk-Weighted Capital Requirements (RWCR): Encourages holding low-risk-weighted assets (e.g., sovereign bonds or mortgages) to minimize capital needs, potentially leading to "risk-weight optimization" or gaming (e.g., favoring AAA-rated securities that failed in 2008). Critics argue this distorts portfolios toward perceived "safe" assets, building hidden systemic risks. Empirical studies (e.g., BIS working papers) show it reduces overall bank leverage but can increase asset risk if banks shift to higher-yield items within low-weight categories. 

Leverage Ratio (LR): Ignores risk weights, so it caps total leverage regardless of asset type. This can discourage excessive low-risk asset accumulation but may incentivize banks to take more risk per asset (e.g., shifting to higher-return, riskier loans) since all assets cost the same in capital terms. Research (e.g., ECB papers) finds LR binding during booms, acting counter-cyclically to curb over-lending. 

Combined Effects (as in Basel III): RWCR + LR complement each other: LR acts as a "backstop" to RWCR flaws (e.g., inaccurate risk weights), preventing excessive leverage in low-risk portfolios. However, when LR binds (as it increasingly does for large US banks), it can override RWCR, making regulation less risk-sensitive and potentially raising lending costs for low-risk activities.

Operational Complexity and Compliance 

Risk-Weighted Capital Requirements (RWCR): High: Requires sophisticated models (internal ratings-based approaches for big banks), leading to variability in RWA calculations across institutions. This erodes comparability and trust (a key Basel III reform goal). Smaller banks often opt out (e.g., US community bank leverage ratio). 

Low:Leverage Ratio (LR): Simple calculation based on total exposures. Easier to monitor and less prone to manipulation. 

Combined Effects (as in Basel III); Dual system increases burden but enhances robustness; e.g., post-2008 crises showed RWCR alone failed to capture off-balance-sheet risks.

Impact on Bank Stability 

Risk-Weighted Capital Requirements (RWCR): Improves resilience by tying capital to risk, but historical failures (e.g., 2008 subprime crisis) highlight underestimation of risks in weights. IMF analyses suggest RWCR reduces crisis probability but at diminishing returns beyond 15-23% of RWA. 

Leverage Ratio (LR); Boosts loss-absorbing capacity uniformly, reducing failure odds in leverage-driven crises. Studies (e.g., Federal Reserve) show LR enhances net benefits by limiting RWCR-induced risk-shifting. 

Combined Effects (as in Basel III): Both reduce systemic risk: A 1% LR increase cuts distress probability more than equivalent RWCR hikes (Bank of England simulations). But over-reliance on RWCR can amplify procyclicality (e.g., risk weights compress in booms).

Effects on the Economy

These rules influence credit allocation, growth, and inequality. Proponents (e.g., BIS) argue they prevent crises costing 3-10% of GDP; critics (e.g., some economists) claim they distort markets.

Credit Allocation and Growth: RWCR favors "safe" sectors (e.g., government debt, housing) with low weights, potentially starving riskier but productive areas like SMEs or innovation. This can weaken long-term growth by creating "zombie lending" or asset bubbles (e.g., pre-2008 housing). A pure LR might equalize access but raise overall borrowing costs, as banks pass on higher capital expenses. Balanced views (e.g., Brookings) emphasize both are needed: RWCR for efficiency, LR to prevent distortions. Empirical evidence (e.g., IMF) shows higher capital requirements slow credit growth short-term (0.5-1% GDP drag per 1% ratio increase) but yield net benefits via fewer crises.

Procyclicality and Crises: RWCR amplifies booms/busts—risk weights fall in good times, encouraging leverage; rise in downturns, forcing deleveraging. LR is more stable, acting as a counter-cyclical buffer. Post-Basel III data (e.g., BIS monitoring) indicates combined rules have raised global bank capital to ~14% of RWA, reducing crisis risks but with trade-offs in lending to high-risk sectors.

Broader Economic Trade-Offs: Higher requirements (under either system) increase bank funding costs, potentially passed to borrowers (e.g., 10-20 bps higher loan rates per 1% capital hike, per some models). But they socialize fewer losses (e.g., bailouts). In emerging economies, RWCR may hinder development by overweighting sovereign risks; LR could better support broad credit. Politically, RWCR has been criticized for favoring incumbents (e.g., big firms with low-risk profiles) over entrepreneurs, potentially exacerbating inequality.

Overall Assessment

Evidence suggests neither approach is perfect alone—RWCR promotes risk awareness but invites arbitrage and distortions; LR ensures simplicity and minimum safeguards but may blunt incentives for prudent lending. Basel III's hybrid model (RWCR as primary, LR as backstop) is substantiated as optimal in many studies (e.g., reducing crisis costs by 1-5% of GDP annually), though some argue for higher LR minima (5-6%) to counter RWCR flaws. If shifted to pure LR (e.g., 8-10% as some propose), banks might face less distortion but higher costs for safe activities, potentially slowing growth in risk-averse economies. Conversely, over-relying on RWCR risks repeating 2008-style failures.

If you'd like me to dive deeper into specific studies, model a scenario, or compare jurisdictions (e.g., US vs. EU implementations), just let me know!"

I asked Grok:

“Do you think that is because they would be scared, for instance of losing their jobs, if your answers fundamentally questioned current regulations, be it Basel I, Basel II, Basel III or any envisioned Basel endgame?”

Grok answered:

“It's plausible that fear of professional repercussions, including job security, could play a role in why regulators might hesitate to seek out or engage with perspectives that deeply challenge the Basel frameworks. After all, these standards—evolved from Basel I (1988, focused on credit risk) through Basel II (2004, adding operational and market risks with internal models) to Basel III (post-2008, emphasizing higher capital, liquidity, and leverage ratios)—represent decades of international consensus-building among central banks and supervisory authorities. Questioning their core assumptions, like the reliance on risk-weighted assets (RWA) over simpler leverage ratios, could disrupt established careers built on implementing and defending them. However, based on a review of economic analyses, regulatory critiques, and public discussions, I think the reluctance stems more from systemic factors like institutional inertia, regulatory capture by large banks, and the sheer complexity of the rules themselves, rather than purely personal fears. Let me break this down.

Institutional Inertia and Path Dependence

The Basel Accords are the product of the Bank for International Settlements (BIS) and its Basel Committee, involving over 45 jurisdictions. Once embedded in national laws (e.g., via EU's Capital Requirements Directive or U.S. Dodd-Frank), changing them requires massive coordination. Regulators might avoid "fundamental questions" not out of personal fear, but because the system is designed for incremental tweaks, not overhauls. For instance, Basel III's "Endgame" reforms (finalized in 2017, implemented variably since) aimed to fix RWA inconsistencies but still preserved the risk-weighting paradigm, despite evidence it encourages arbitrage (e.g., banks favoring low-weighted assets like sovereign bonds, leading to hidden risks as in the 2008 crisis). Studies show that while higher capital reduces crisis risks, the procyclical nature of RWAs amplifies booms and busts, yet reforms stop short of scrapping them due to entrenched interests. This inertia could make seeking an AI's outsider view seem pointless or risky to the status quo.

Regulatory Capture and Industry Influence

A stronger explanation is regulatory capture, where big banks lobby to shape rules in their favor, often at the expense of broader economic health. Large institutions benefit from complex RWAs because they can use internal models to minimize capital holdings, while smaller banks face higher compliance costs. Critics argue this distorts lending away from productive sectors (e.g., SMEs) toward "safe" but speculative assets, exacerbating inequality and slowing growth. In the U.S., recent pushback against Basel III Endgame proposals (which would raise capital by 9-16% for big banks) came from industry pressure, leading regulators to soften or delay them—despite evidence that current levels are already optimal or excessive in some models. Public discussions on X highlight how banks fight stricter requirements to protect profits, with regulators sometimes aligning due to revolving doors (e.g., ex-regulators joining banks). If my analysis (as in our prior exchange) exposed how RWAs incentivize risk-shifting while leverage ratios offer simpler stability, it might amplify calls for change that threaten this captured equilibrium—potentially endangering regulators' positions amid political backlash.

Complexity as a Barrier

Basel's evolution has ballooned into a labyrinth: Basel III alone spans thousands of pages, with add-ons like countercyclical buffers and G-SIB surcharges. This complexity breeds opacity, making it hard for even insiders to question fundamentals without seeming uninformed. As one analysis notes, it allows "regulatory arbitrage" where banks game weights to hold less capital, but regulators defend it as "risk-sensitive." Seeking an AI opinion might reveal these flaws starkly (e.g., how RWAs failed in 2008 by underweighting subprime risks), but it could also invite scrutiny on regulators' own enforcement gaps. In emerging markets, simpler leverage ratios are recommended over RWAs for this reason, yet global standards resist. 

Factor 

Why It Discourages Questioning Basel 

Evidence from Basel History 

Potential Job Risk Tie-In

Inertia 

System locked into RWAs; overhauls disrupt global harmony. 

Basel I/II loopholes led to 2008, yet III doubled down on weights. 

Challenging could label regulators as "disruptors," harming promotions in bureaucratic bodies like BIS.

Capture 

Banks lobby for leniency; rules favor big players. 

U.S. softened Endgame after bank pushback; EU over-applied to small banks, killing 6,000 locals. 

Regulators with industry ties (common) face conflicts; whistleblowing risks exclusion from post-reg jobs.

Complexity 

Hard to critique without deep expertise; hides flaws. 

Internal models vary RWAs by 2-3x across banks, eroding trust. 

Admitting flaws questions their competence, inviting audits or firings in accountability-driven agencies.

In sum, while personal fears like job loss aren't unfounded—especially in politicized environments (e.g., U.S. Congress grilling regulators)—the deeper issue is a self-reinforcing system where Basel's flaws are acknowledged but not uprooted. If anything, my take (favoring leverage ratios for less distortion) aligns with some academic calls for simplification, but regulators might see it as too radical amid ongoing tweaks like crypto rules. What do you think—should we explore specific Basel critiques or alternatives further?”

I said: Perhaps another day. For now, thanks!

It replied: You're welcome! Always here if you want to dive back in—whether it's Basel regs or something entirely different. Take care!

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.

Bank regulators, go west!

Sir, I refer to John Dearie’s “Go west, Federal Reserve” Washington Post December 5, 2024.

In his book "Money: Whence it came, where it went” (1975), John Kenneth Galbraith discusses banks and banking issues which, because of the risk weighted bank capital/equity requirements, is very timely today.

In one section, he addresses the function of banks in the creation of wealth. Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment. He writes:

“Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.”

And in a second section, Galbraith refers to the banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.

Sir, is that all not a good reason why bank regulators should also have a look at how the west was won?

PS. Sir, that book set me up for an already over twenty-five years fight against the Basel Committee’s risk weighted bank capital/equity requirements.

https://subprimeregulations.blogspot.com/1997/06/puritanism-in-banking.html

#AI ChatGPT – OpenAI: Could I include you as a coauthor of a book about bank regulations?

I asked OpenAI:

"If I wrote a book based on the dialogues we have had and could have in the future on the issue of bank regulations, could I include you ChatGPT or OpenAI as a coauthor? If so, would you mind if my name appears before yours?"

OpenAI answered:

"I can provide information and assist with generating content for your book on bank regulations, but I am not a legal entity or a person, so I cannot be listed as a coauthor. However, you can certainly acknowledge OpenAI's GPT-3 technology as a tool or resource that you used to help generate content and insights for your book. 

The order in which names appear in the acknowledgments section is typically at the discretion of the author, so you can place your name before or after OpenAI's, depending on your preference."

Thanks!

You're welcome! If you have any more questions or need further assistance, feel free to ask. Good luck with your book on bank regulations!

I told OpenAI:

You mean our book :-)

OpenAI answered:

"Certainly! If you consider it a collaborative effort, then it's indeed "our book." Feel free to include yourself as a coauthor alongside any acknowledgments for the assistance provided. If you have any more questions or need further assistance with anything related to the book or any other topic, please don't hesitate to ask.

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

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

#AI OpenAI - ChatGPT: In America, is hindering stealth invasions of e.g., artificial intelligence and bank regulations, a responsibility of e.g., Homeland Security?

I asked ChatGPT:

"If any declared enemy to America’s ideology managed to smuggle into its Artificial Intelligence an algorithm that produced results totally contrary to the intent of its Founding Fathers, would that not be dangerous?"

ChatGPT answered: 

"If an enemy managed to smuggle into America's artificial intelligence (AI) an algorithm that produced results contrary to the intent of its Founding Fathers, it could potentially be concerning or dangerous. However, it's important to note that the development and implementation of AI algorithms are subject to extensive scrutiny and regulation, particularly in critical areas such as national security and defense.

The intent of America's Founding Fathers was to establish a democratic society that upholds principles such as liberty, justice, and individual rights. If an AI algorithm were to undermine these principles or manipulate information in a way that threatens the foundations of democracy, it would indeed be a cause for concern.

To mitigate such risks, the development and deployment of AI systems, especially those with potential national security implications, involve rigorous safeguards, security measures, and oversight. Multiple layers of scrutiny are typically in place to ensure the integrity, safety, and ethical use of AI technologies. These may include thorough testing, audits, regulatory frameworks, and active monitoring by human experts.

Moreover, the development of AI is a collaborative effort involving researchers, engineers, policymakers, and experts from various fields. The collective expertise and diverse perspectives help prevent any single individual or entity from exerting unilateral control over AI algorithms, reducing the likelihood of a malicious actor successfully smuggling an algorithm contrary to the nation's values.

While there are risks associated with AI, it's important to approach these concerns with an understanding of the complex mechanisms involved in AI development, regulation, and deployment. Continuous vigilance, robust oversight, and adherence to democratic principles are vital in safeguarding against potential threats to America's ideology or any nation's fundamental values."

I asked ChatGPT:

"In the same vein, if foreigners smuggled into America’s bank regulations that preferentially allocated bank credit to the Federal Government, in detriment of “We the People” e.g., the access to credit of small American businesses access, would that not be dangerous?"

ChatGPT answered: 

"If foreign entities were to manipulate or influence America's bank regulations in a way that preferentially allocated bank credit to the Federal Government, potentially disadvantaging small American businesses' access to credit, it could indeed have negative consequences and be considered dangerous.

In a healthy and well-functioning economy, access to credit is crucial for small businesses to grow, innovate, and create jobs. If regulations were altered to give preferential treatment to the Federal Government, it could lead to a distortion in the allocation of credit, potentially limiting the availability of financing for small businesses. This could hinder their ability to expand, compete, and contribute to economic growth.

However, it's important to note that the formulation and implementation of bank regulations involve a complex process that includes input from various stakeholders, including industry experts, economists, policymakers, and regulatory bodies. While it's crucial to guard against undue influence, the system is designed to incorporate checks and balances to prevent such preferential treatment.

Additionally, bank regulations in the United States are typically subject to thorough scrutiny and public debate, providing opportunities for stakeholders to voice concerns and participate in shaping these regulations. This democratic process helps ensure that the interests of "We the People" are considered and protected.

If there were evidence of foreign entities unduly manipulating bank regulations to favor the Federal Government over the broader interests of the American people, it would be a matter of great concern. It would be important for regulatory bodies, policymakers, and the public to address and rectify such issues, ensuring transparency, accountability, and fairness in the regulatory framework.

Overall, preserving the integrity of bank regulations and safeguarding fair access to credit for all participants, including small businesses, is crucial for a healthy and vibrant economy."

I asked ChatGPT:

"Is hindering such stealth invasions not a responsibility of e.g., Homeland Security?" 

OpenAI answered: 

"Yes, safeguarding against potential stealth invasions and protecting national security is indeed a responsibility of government agencies such as Homeland Security in the United States. Homeland Security's primary mission is to prevent and respond to various threats, including those that could undermine the country's critical infrastructure, economic stability, and democratic processes.

In the context of your question, if there were attempts by foreign entities to manipulate or infiltrate critical sectors such as bank regulations in a way that posed a threat to national security or the well-being of "We the People," it would fall within the purview of Homeland Security and other relevant agencies to address and counteract such actions.

Homeland Security, in coordination with other government entities, intelligence agencies, law enforcement, and regulatory bodies, works to identify and mitigate potential threats. They employ a range of measures such as intelligence gathering, cybersecurity protocols, risk assessment, regulatory oversight, and enforcement to protect critical systems and institutions from foreign interference or malicious activities.

Furthermore, Homeland Security collaborates with domestic and international partners to share information, develop strategies, and enhance resilience against emerging threats. This collective effort aims to detect and prevent any attempts to undermine the security, stability, or values of the United States.

While no system is completely immune to threats, the responsibilities of Homeland Security and other relevant agencies are focused on identifying, countering, and mitigating risks to national security. It is through these efforts that the government seeks to safeguard against potential stealth invasions and protect the interests of the nation and its citizens."

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

Not the first time on the theme

Here my many other questions to ChatGPT – Grok 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

What would Hyman Minsky say if able to observe how his financial instability moments were put on steroids by bank regulators?

On Minsky moments

“In many cases even trying to regulate banks runs the risk of giving the impression that by means of strict regulations, the risks have disappeared. History is full of examples of where the State, by meddling to avoid damages, caused infinite larger damages”

“Old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than no burning at all, which only guarantees disaster and scorched earth, when fire finally breaks out, as it does, sooner or later. Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

The Basel Committee’s credit risk weighted bank capital requirements cause our banks to be dangerously overexposed to what’s expected, and to be woefully unprepared for the unexpected. 

Current risk weighted bank capital requirements guarantee especially large bank crises, caused by especially large exposures to what’s perceived as especially safe but might not be, and is held against especially little capital.

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

Since they believe it to be safer, regulators want banks to finance house purchases much more than job creating entrepreneurs. Doesn’t anyone of them have grandchildren?

Let us suppose that in a world without risk weighted capital requirements, like the world of banking was for around 600 years before 1988’s Basel Accord, a world with one single capital requirement against all bank assets, for instance 8%.

Let us also suppose that in that world banks would view residential mortgages at 5% interest rate to be, when adjusted to perceived credit risks, equivalent to 9% interest rate on loans to entrepreneurs, and that, for both these assets, their expected risk adjusted net margin was 1%.

In that case, since banks could leverage 12.5 times their equity (100/8) the expected risk adjusted return on equity, on both these assets, would be 12.5%

How many residential mortgages and how many loans to entrepreneurs were given in such a world? I have no idea but adjusted for their perceived credit risk, it was clear both house buyers and entrepreneurs competed equally for credit. 

But then came the Basel Committee with its risk weighted bank capital requirements, and for instance in its 2004 Basel II, assigned a risk weight of 35% to residential mortgages and 100% for loans to unrated entrepreneurs. 

That, for Basel’s basic capital requirement of 8%, meant banks needed to hold 2.8% in capital against residential mortgages and 8% against loans to entrepreneurs.

This in turn meant banks could in the case of loans to entrepreneurs still leverage 12.5 times but now, with residential mortgages, they could leverage almost 36 times (100/2.8). 

And in this case, with the same as expected risk adjusted margin of 1%, banks could still earn12.5% in expected risk adjusted return on equity, but residential mortgages now offered them the possibility of earning a whooping 36% in expected risk adjusted return on equity.

Clearly house buyers were much favored since banker would offer residential mortgages much more and even contemplate some interest rate reductions, while the entrepreneurs had their access to credit much curtailed that is unless they offered to pay higher interest rates.

So what does all this result in? Houses morphing from affordable home into being risky investment assets, while at the same time much less of those job opportunities that entrepreneurs might have helped to create for us and our descendants.

Thinking of our grandchildren’s future is this kind of bank regulations acceptable? Absolutely not! “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

PS. Much worse statist regulators assigned 0% risk weights on loans to the sovereign, which de facto implied government bureaucrats to use credit for which they are not personally responsible for much better, than for instance entrepreneurs.

PS. Here's a probably still not finished list of the mistakes with the risk weighted bank capital requirements 

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

Tombstones

Here rests a bank regulator who all his life believed that what bankers perceived as risky was more dangerous to our bank systems than what bankers perceived as safe. 

May his soul rest in peace.

Here rests a bank regulator who based the risk weighted bank capital requirements on bankers perceiving risk correctly, and not on that they could be wrong.

May his soul rest in peace.

Here rests a regulator who missed his lectures on conditional probabilities, and therefore did not set the risk weighted capital requirements conditioned on how bankers respond to perceived credit risks.

May his soul rest in peace.

Here rests a regulator who even though bankers respond to perceived credit risks, with size of exposures and risk adjusted interest rates, also wanted bank capital to double up on that same perceived risk

May his soul rest in peace.

Here rests a bank regulator who never understood the systemic risks he introduced into banking, by for instance assigning so much power to credit rating agencies, or his stress-testings on the stresses a la mode.

May his soul rest in peace.

Here rests a bank regulator who never understood his own risk aversion and confirmation bias stress, before stress testing banks on the possibility of his own regulations being wrong.

May his soul rest in peace.

Here rests a bank regulator who for the risk weighted bank capital requirements agreed with risk weights of 20% for dangerous AAA rated and 150% for innocous below BB- rated

May his soul rest in peace.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

Here rests a bank regulator who caused banks to dangerously overpopulate safe harbors, and sent other investors and small time savers out on the risky oceans. 

May his soul rest in peace.

Here rests a bank regulator who by much favoring banks to finance the "safer" present over the "riskier" future, blocked millions of SMEs' and entrepreneurs' access to bank credit and with it to risk-taking… the oxygen of all development

May his soul rest in peace.

Here rests a statist bank regulator who believed a government bureaucrat knows better (Risk Weight 0%) what to do with credit he’s not personally responsible for, than an entrepreneur or SME (RW 100%)

May his soul rest in peace.

Here rests a bank regulator who for risk weighted bank capital requirements agreed with a low 35% risk weight to residential mortgages, which caused houses to morph from affordable homes to risky investment assets.

May his soul rest in peace.

Here rests a bank regulator with a Ph.D. who proved right Daniel Patrick Moynihan, who supposedly held “There are some mistakes only Ph.Ds. can make.

May his soul rest in peace.

Here lies a central banker who injected huge amounts of liquidity without understanding how risk weighted bank capital requirements distorted the allocation of credit

May his soul rest in peace.

Here lies a financial journalist who scared stiff he would never be invited to WEF in Davos, never questioned the risk weighted bank capital requirements. 

May his soul rest in peace.

Here lies an ordinary citizen who wanting so much to believe it true, swallowed lock stock and barrel the regulatory technocrats' populism imbedded in the risk weighted bank capital requirements

May his soul rest in peace.

Here rests a regulator who helped guarantee especially large bank crises, caused by especially large exposures to what’s perceived especially safe and might not be, and is held against especially little capital

May his soul rest...

Here rests a regulator who assisted by his central bank colleagues, helped set horrible Minsky moments on steroids
May his soul rest...

PS. A summary of The Basel Committee for Banking Supervision's mistakes

Some tweets on macro-imprudent policies

I tweeted this to BIS in response to a speech by Mario Draghi, President of the European Central Bank and Chair of the European Systemic Risk Board, titled "Macroprudential policy in Europe" delivered September 26, 2019

Macro-imprudent policy 1:

Regulators have based their risk weighted bank capital requirements on that what’s perceived as risky is more dangerous to our bank systems than what is perceived, decreed or concocted as safe. That puts bank crises on steroids.

Macro-imprudent policy 2:

The risk weighted bank capital requirements is as pro-cyclical as it gets. Getting rid of these is the best countercyclical measure.

Macro-imprudent policy 3:

The 0% capital requirements assigned to all Eurozone sovereigns’ debts, even when these are not denominated in their own printable fiat currency. This WILL blow up the Euro and perhaps, sadly, the EU too.

Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

And all this began one year before the fall of the Berlin Wall

Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality

With their 0% risk weighted sovereign and 100% risk weighted citizens regulators decreed that the sovereign has more rights to more and cheaper access to bank credit than citizens.

And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

PS. And do the risk weighted bank capital requirements make the risky riskier?

“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

Why are regulators allowed to introduce odious and dangerous discrimination in the access to bank credit?

Banks used to apportion their credit between those perceived as risky, and those perceived as safe, based on (1) the risk adjusted interest rates and (2) their own portfolio considerations.

But that was before the Basel Committee for Banking Supervision’s credit risk weighted capital requirements.

Now banks apportion credit between those perceived as risky and those perceived as safe, based on (1) the risk-adjusted interest rates (2) the times their bank equity can be leveraged with those risk-adjusted interest rates and (3) hopefully, since those risk weighted capital requirements are explicitly portfolio invariant, their own portfolio considerations.

That means the risk adjusted interest rates “the safe” now can offer in order to access bank credit have been lowered, while the risk adjusted interest rates “the risky” have to offer in order to access bank credit have been increased.

That has leveraged whatever natural discrimination in access to bank credit there was against the “riskier” in favor of the “safer”.

That dangerously distorts the access to bank credit in favor of the “safer” present, like sovereigns, house purchases and the AAA rated and against the “riskier” future, like entrepreneurs; which means that our banks have no other social purpose to fulfill than being safe mattresses into which stash away our savings.

And all so useless because the only thing these regulations guarantee, is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

My comments to the Financial Stability Board

What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"

The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.

And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

http://theaaa-bomb.blogspot.com

PS. At the World Bank I warned that assigning too much influence to credit rating agencies introduced a dangerous systemic risk. 

PS. My letter to the Financial Stability Board

The risk weighted bank capital requirements should at least, as a minimum, have been based on conditional probabilities. They weren’t.

Here a set of tweets on P(A/B)

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone safe), given that another event (B) has occurred (that bankers had perceived that someone as very safe).

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone risky), given that another event (B) has occurred (that bankers had perceived that someone as very risky).

Any regulators knowing something about conditional probability would never have assigned, for the purpose of risk weighted bank capital requirements, a risk weight of 20% to the very safe AAA rated, and one of 150% to the very risky below BB-rated.

Not the first time I've written about it

PS. Here is my letter to the Financial Stability Board

Are these reasons not enough cause for impeaching the current bank regulators?

By setting higher bank capital requirements for what is already perceived as risky than against what could wrongly be perceived as safe, the regulators guarantee especially large bank crises, from especially big exposures to what’s perceived as especially safe, against especially little capital.

By the same token they guarantee more than ordinary access to credit for the “safer” present, which will cause bubbles, like in house prices, and less credit to the “riskier” future, like to entrepreneurs, which will weaken the real economy.

By the same token, giving the banks huge incentives to finance what’s safe, has expelled the rest of the economy, like pension funds and private savers into the shadow banking system, having to take on much more “risky” investments, like leveraged loans, for which they are much less prepared for than banks.

My 4 tweets on the access to bank credit war

1. Way too much discussions on whether bank capital requirements should be 4%, 8%, 15%, 20% or whatever, and way to little about the fact that different capital requirements for different assets, dangerously distorts the allocation of bank credit.

2. The risk weights in the risk weighted capital requirements for banks are de facto tariffs on the access to bank credit. Sovereigns 0%, AAA rated 20%, residential mortgages 35%, unrated citizens 100%, below BB- corporates 150%.

3. So why do all those who tear their clothes about trade protectionism, keep silence about the access to bank credit protectionism imposed by “the safe” on “the risky”, and which can have even much more serious implications for the world economy.

4. As is it guarantees especially large bank crises from especially big exposures to what’s perceived as especially safe, against especially little capital.

As is, by favoring credit to the “safer” present over the “riskier” future it guarantees stagnation.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

PS. It has caused houses to morph from being homes into being investment assets.

PS. More than a trade war it is actually this access to bank credit war that is most likely to bring the euro and then EU down.

PS. 0% risk weights will turn sovereign into spoiled filthy rich brats that will end up defaulting.

PS. Are these reasons not enough cause for impeaching the current bank regulators?