ChatGPT – OpenAI: If large bank exposures that detonated major bank crises were all built-up with what’s perceived as safe, how does that square with current risk weighted bank capital requirements?

I asked OpenAI:

"Current risk weighted bank capital requirements are based on what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe. How does that square with that the large bank exposures that detonated major bank crises were all built-up with what’s perceived as safe?"

OpenAI answered:

"You bring up an important point regarding the perception of risk in the banking system and its relationship to major bank crises. It is true that historically, some major bank crises have been associated with exposures that were considered "safe" or low risk according to prevailing perceptions at the time. This phenomenon is often referred to as the "risk paradox" or "risk perception problem."

One reason behind this risk paradox is that risk perceptions in the banking industry can be influenced by various factors, including market conditions, prevailing economic assumptions, and regulatory frameworks. These perceptions may not always accurately reflect the true underlying risks associated with certain assets or activities. As a result, banks and regulators may focus on addressing the perceived risks while overlooking or underestimating the potential risks embedded in seemingly safe assets or activities.

In the context of risk-weighted capital requirements, the challenge lies in the accurate assessment and calibration of risk weights assigned to different assets. If risk weights do not adequately capture the true risk of an asset, it can create a discrepancy between the perceived risk and the actual risk. This can lead to unintended consequences, such as the excessive allocation of credit to assets with lower perceived risks but higher actual risks.

Furthermore, financial innovations and complex financial products can further complicate risk assessments. These products often involve multiple layers of risk and interdependencies, making it difficult to accurately capture their true risk profiles. In such cases, there is a risk of underestimating the risks associated with these products, leading to potential vulnerabilities in the banking system.

It is worth noting that regulators and standard-setting bodies, such as the Basel Committee on Banking Supervision, continuously work to improve risk measurement methodologies and enhance the accuracy of risk-weighted capital requirements. For example, Basel III introduced more stringent rules for risk measurement, capital buffers, and stress testing to address some of these issues.

However, it is important to acknowledge that risk measurement and regulation in banking are complex tasks, and there will always be inherent limitations in capturing all risks accurately. The banking industry and regulators must remain vigilant, regularly reassess their risk models and frameworks, and learn from past crises to continually improve risk management practices and enhance financial stability.

In conclusion, the risk paradox you highlighted underscores the challenges in accurately assessing and managing risks in the banking system. The perception of safety can sometimes be deceptive, and the industry must remain attentive to the potential risks embedded in seemingly safe assets or activities. Ongoing efforts are necessary to improve risk measurement methodologies, enhance risk management practices, and strengthen regulatory frameworks to minimize the likelihood and impact of major bank crises."

I asked OpenAI:

"Do you know of any major bank crisis caused by large bank exposures built-up with assets perceived as risky?"

OpenAI answered:

"Yes, there have been major bank crises caused by large bank exposures built-up with assets perceived as risky. One prominent example is the global financial crisis of 2008, which was triggered by the collapse of the U.S. subprime mortgage market.

In the years leading up to the crisis, financial institutions accumulated significant exposures to mortgage-backed securities (MBS) and related derivatives. These assets were often perceived as relatively risky due to their connection to subprime mortgages, which were home loans extended to borrowers with weaker credit histories. However, these assets were also considered to carry low risk according to prevailing risk models and credit rating agencies.

Financial institutions, including major banks, invested heavily in these mortgage-backed securities, often leveraging their positions. They believed that the risk of default on these assets was low due to assumptions that housing prices would continue to rise and that the risks were adequately diversified through securitization and credit derivatives.

However, when the U.S. housing market experienced a significant downturn, many subprime borrowers defaulted on their mortgage payments. This led to a rapid and severe decline in the value of mortgage-backed securities, triggering substantial losses for banks and other financial institutions. The interconnectedness of the global financial system exacerbated the crisis, as losses in one institution or market spread throughout the system.

The global financial crisis demonstrated how large exposures to assets perceived as risky, but treated as safe in risk models and ratings, can have severe consequences for the banking system. It exposed the limitations of risk assessment models and highlighted the potential for systemic risk when institutions heavily rely on assets with underappreciated risks.

It is important to note that the crisis was not solely caused by exposures to perceived risky assets, but also by a range of other factors such as lax lending standards, inadequate risk management, complex financial products, and the interconnectedness of global financial markets. Nonetheless, the misperception and underestimation of risks associated with assets considered risky played a significant role in the crisis."

I asked OpenAI:

"Lower bank capital requirements against what’s perceived as safe than against what’s perceived as risky, does that increase the dangers of what is known as the “risk paradox?"

OpenAI answered:

"Lower bank capital requirements against assets perceived as safe compared to those perceived as risky can indeed contribute to the risk paradox and increase the dangers associated with it. This is because such a regulatory framework can create incentives for banks to allocate a larger portion of their portfolios towards assets deemed safe, even if those assets carry hidden or underestimated risks.

When capital requirements are lower for assets perceived as safe, banks have a financial incentive to hold more of these assets in order to optimize their capital ratios. This can lead to an overemphasis on assets with lower risk weights, as they allow banks to achieve higher capital efficiency. However, as we have seen in the past, the perception of safety does not always align with the true underlying risks.

The risk paradox arises when banks and regulators focus on addressing the perceived risks rather than accurately assessing the actual risks associated with various assets or activities. By assigning lower capital requirements to assets perceived as safe, the regulatory framework may unintentionally encourage banks to allocate credit towards these assets without fully accounting for their hidden or underestimated risks.

The dangers of the risk paradox are amplified when seemingly safe assets turn out to be riskier than expected. This can happen due to various factors, such as sudden changes in market conditions, unforeseen interdependencies, or flaws in risk assessment models. If a significant number of banks hold large exposures to such risky assets, it can create systemic vulnerabilities and increase the potential for widespread financial distress.

To mitigate the dangers of the risk paradox, it is crucial for regulators to continuously reassess and improve risk assessment methodologies and capital requirements. This includes regularly reviewing and updating risk weights assigned to different asset classes based on a thorough understanding of their true underlying risks. Additionally, stress testing and scenario analysis can help identify vulnerabilities and ensure that banks are adequately capitalized against various risk scenarios.

The regulatory framework should also promote a holistic and comprehensive approach to risk management that goes beyond relying solely on risk weights. This can include considering factors such as concentration risk, interconnectedness, and the potential for contagion.

By implementing a robust and dynamic regulatory framework that appropriately addresses both perceived and actual risks, regulators can help mitigate the dangers associated with the risk paradox and promote a more resilient banking system."

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: Credit rating agencies, empowered by bank capital/equity requirements, is that a systemic risk?

As an Executive Director at the World Bank, I often warned that assigning some few human fallible credit rating agencies so much power for deciding how much capital/equity banks needed to hold against assets, introduced a huge systemic risk in the financial sector. E.g.:

http://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

http://subprimeregulations.blogspot.com/2007/06/some-comments-made-at-risk-management.html

https://subprimeregulations.blogspot.com/2007/09/factors-in-financial-storm.html

Given now the opportunity to chat with ChatGPT – OpenAI, I asked:

"Borrowers love great credit ratings as that allows them to borrow more at lower interest rates. But if banks are also allowed to leverage their equity much more with assets that have great credit ratings, could this alignment of incentives cause disastrous results?"

OpenAI answered:

"The alignment of incentives between borrowers and banks regarding credit ratings can indeed create potential risks and contribute to financial instability if not properly regulated. While borrowers benefit from lower interest rates and increased borrowing capacity with excellent credit ratings, banks may be tempted to leverage their equity more with assets that have high credit ratings.

This situation can lead to several problems:

1. Excessive risk-taking: Banks may become overly confident in the safety of assets with high credit ratings and increase their leverage beyond reasonable levels. This behavior can result in a higher concentration of risk within the financial system.

2. Mispricing of risk: If banks rely too heavily on credit ratings without conducting their due diligence, they may underestimate the true risk associated with certain assets. This mispricing can create a false sense of security and lead to the accumulation of risky assets in the banking system.

3. Contagion effect: In the event of a downturn or a shock to the financial system, the interconnectedness of banks and their reliance on highly rated assets can amplify the impact and lead to contagion. If the credit quality of these assets deteriorates, multiple institutions could face severe losses simultaneously.

4. Systemic risk: When a large number of banks engage in excessive leverage based on assets with great credit ratings, the overall stability of the financial system may be compromised. If these assets were to experience a sudden decline in value or suffer from rating downgrades, it could trigger a broader financial crisis.

To mitigate these risks, regulatory measures are necessary. Regulators should ensure that banks have robust risk management frameworks in place and are not solely relying on credit ratings when assessing the quality and risk of assets. Strengthening capital and liquidity requirements can also enhance the resilience of banks and mitigate the potential negative effects of excessive leverage.

Moreover, improving the accuracy and transparency of credit ratings and reducing conflicts of interest in the rating process can contribute to a more reliable assessment of risk. This would help prevent a situation where banks overly rely on ratings without conducting their independent analysis.

Overall, it is crucial to strike a balance between encouraging lending and maintaining the stability of the financial system."

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

My brevissimus criticism lecture on the Basel Committee’s bank regulations

Students. 

Let’s refer to two types of bank assets, those perceived as safe, e.g., government debt and residential mortgages; and those perceived as risky, e.g., loans to small businesses and entrepreneurs.

Let’s also assume all these assets, whether the Safe or the Risky, are offering perfect risk adjusted interest rates.

Before the Basel Committee regulations, the banks, with a general look to the safety of their whole portfolio, would have given all of these assets, whether safe or risky, a quite similar consideration.

But, when the Basel Committee imposed risk weighted bank capital requirements, more capital/equity for what’s perceived as risky than for what’s perceived (or decreed) as safe, that all changed.

Because banks can now leverage their capital/equity much more with what’s “safe”, the risk adjusted interest rates offered by the Safe, produce them higher risk adjusted returns on their equity, than the risk adjusted interest rates offered by the Risky.

That dramatically distorted the allocation of bank credit. 

The Safe now get too much credit, often at rates lower than what their correct risk adjusted interest rate would demand. As a consequence, excessive bank exposures are construed, turning the Safe effectively into risky and very dangerous to the stability of bank systems. (Have you ever heard of a dangerous asset bubble built-up with assets perceived as risky?)

The Risky now get too little credit and, whatever they get, is at interest rates higher than what their correct risk adjusted interest rates would merit. As a consequence, the Risky become riskier, and too little risk-taking, the oxygen of all development, takes place, something which, of course, weakens the economy.

Why would regulators do this? As Paul Volcker (valiantly) confessed “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

Students, one big problem is that the Academia seem not to care one iota about it, so this might have been your only chance to hear this explanation. 

Why should you care? Having banks give much priority to refinancing the safer present than financing the riskier future, cannot be in your best interests.

Fed, during the last 15 years what were the capital requirements for a US bank when lending to Puerto Rico?

The single most important reason for which Greece’s debt levels got so out of whack was that the European bank regulators, out of misunderstood solidarity, also gave Greece, for purposes of capital requirements for banks a 0% risk weight. 

That of course allowed banks to leverage much more loans to Greece than loans let us say to an unrated European SME, which of course allowed banks to earn higher risk adjusted returns on equity lending to Greece than lending to an unrated European SME. (The Greek citizens now suffering have not held those regulators accountable for that lunacy)

Now we read: “The Puerto Rico debt, a result of generations of mismanagement, was enabled by Wall Street, which was enticed by the fact it was tax free everywhere in the U.S. and risky enough to provide rich yields.” “Trump Suggests Puerto Rico’s Debt May Need to Be ‘Wiped Out’” Justin Sink, Bloomberg, October 3.

“Mismanagement?” With respect to debt it takes as a minimum two to tango, the borrower and the creditor; and since distorting risk weighted capital requirements were introduced, the regulators also participate in that dance. 

So my immediate info request to the Fed would be: Over the last 15 years, so that we have some pre 2007-08 crisis figures too, can you show us precisely the evolution of how much capital American banks were required to hold when lending to Puerto Rico?

Who knows, Puerto Rican citizens might want to sue the Fed for stimulating an excessive lending/borrowing to Puerto Rico.

PS. It would also be interesting to know how much banks were required to hold against loans to unrated SMEs in Puerto Rico. To compare those requirements would allow us to establish whether there was some statist regulatory favoritism of the Puerto Rico government. 

The Riskiness of Country Risk

An Unsustainable Debt Sustainability 

Regulators make banks finance “safe” basements where young can live with their parents, not the risky jobs they need.

Ever since regulators introduced credit risk weighted capital requirements for banks, these are not financing sufficiently the "riskier" future, only refinancing excessively the "safer" past and present.

For instance, the risk weight of 35% when financing “safe” houses, and of 100% when financing “risky” SMEs, results only in the building of basements where the young can live with their parents, and not in the creation of the new generation of jobs the young need.

Here's an aide memoire on the monstrous mistakes of such capital requirements.

P.S. Washington Post. December 2018: “Affordable homes or houses as investment/retirement assets?”

When and where did the last bank crisis resulting from excessive exposures to something ex ante believed risky occur?

I don't know. Ask the regulators in the Basel Committee on Banking Supervision and the Financial Stability Board. 

I mean they must have much data on this because, without it, why would they impose credit risk weighted capital requirements for banks, knowing that carried the huge cost of distorting the allocation of bank credit to the real economy?

I mean that if they use the theorem that what's perceived as risky is riskier to the bank system than what is perceived as safe, then they are indeed using a loony theorem.

Or did they not look for the data?  Or did they not understand it?

Evidence that demonstrates, without any reasonable doubt, we have landed us some very feeble-minded bank regulators

What are the chances banks build up huge exposures to those rated prime, AAA to AA, and which could be dangerous to the bank system, if these, ex post, turn out to have been worthy of a much lower rating? Big!

What are the chances banks build up dangerously large exposures to those rated “highly speculative “ and worse below BB-? None! 

And yet the regulators, for the purposes of determining the capital requirements for banks, in Basel II, assigned to the AAA to AA rated, a risk weight of 20%, and to the below BB- rated, a risk weight of 150%.

And to top it up, the risk weights are portfolio invariant.

Do we really need more evidence that the Basel Committee regulators and those affiliated to it are cuckoo?

They behave like nannies telling the children “Stay away from the ugly and foul smelling, and embrace the nice gents bringing you candy”, and so dangerously distort the allocation of bank credit to the real economy.

Voltaire to the Basel Committee: “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [BB- rated]”

Here is a brief memo that further explains their idiocy.

Bank regulators… dare to answer this single question

There are literally thousand of risks, especially many unexpected risks, which could bring our banking system down.

And so why on earth did you regulators base your capital requirements for banks, those which are to cover especially for unexpected risks, solely on the ex ante perceived credit risk, that which is basically the only risk already cleared for by banks, by means of interests risk premiums and the size of their exposures?

And, to top it up, you made those capital requirements portfolio invariant… as if diversification has no meaning?

If anything, should you not have based it on the risks that bankers were not able to clear for those perceived risks?

Since that dangerously distorts the allocation of bank credit to the real economy, do we not deserve a clear-cut answer on that?

I have been asking this for over a decade, and you have not even wanted to acknowledge my question. Does that not tell you something?

Bank regulators, why, why, why?

If all bank crisis in history have resulted from the build-up of excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever from the build-up of excessive exposures to what was perceived as risky… what is the rationale behind capital requirements for banks which are much lower for what is perceived as absolutely safe, or at least very safe, than those for what is perceived as “risky”? 

Some questions today to The Masters of Risk