#AI ChatGPT – OpenAI: Regulators, when imposing risk weighted bank capital requirements, which implies some degree of hubris, are they as professionals behaving ethically?

I asked OpenAI:

"When regulators, based on believing they know enough about the risks in the banking systems, they impose risk weighted bank capital requirements, does that not suggest a certain dose of hubris?"

OpenAI answered:

"Yes, the imposition of risk-weighted bank capital requirements by regulators based on the belief that they possess sufficient knowledge about the risks in the banking system can indeed suggest a certain level of hubris. Hubris refers to excessive pride, overconfidence, or arrogance, often accompanied by a belief in one's superiority or infallibility.

In the context you described, if regulators firmly believe they possess a comprehensive understanding of the risks and subsequently impose risk-weighted capital requirements without considering alternative perspectives or acknowledging potential limitations in their knowledge, it can indicate a degree of hubris. It suggests they may be overly confident in their ability to accurately assess risks and determine appropriate capital requirements.

Hubris can be problematic because it can lead to the neglect of important information, blind spots in decision-making, and an underestimation of the complexity and uncertainty inherent in financial systems. It is generally considered more prudent and responsible for regulators to approach their decision-making processes with a certain level of humility, acknowledging the limitations of their knowledge and seeking input from various sources to ensure a well-rounded understanding of risks.

However, it's important to note that not all instances of confidence or assertiveness in regulatory actions necessarily imply hubris. Assessing hubris requires a more comprehensive understanding of the specific behaviors, attitudes, and intentions of the regulators involved."

I asked OpenAI:

"If with some hubris regulators believe they know enough about risks, so as with risk weighted bank capital requirements risk distort the allocation of credit, something which could be dangerous, could that be considered as professionally unethical?"

OpenAI answered:

"Determining whether a specific action is professionally unethical requires a nuanced assessment of the context and motivations involved. However, I can provide some general insights that may help you evaluate the situation you described.

If regulators, driven by hubris, impose risk-weighted bank capital requirements that distort the allocation of credit and potentially create dangerous consequences, it could be viewed as a professional ethical concern for a few reasons:

1. Lack of competence: If regulators believe they possess comprehensive knowledge about risks but their actions lead to distorted credit allocation and potential dangers, it suggests a lack of competence. Ethical responsibility entails recognizing one's limitations and seeking input from diverse perspectives to make informed decisions.

2. Neglecting public interest: Regulators have a responsibility to act in the public interest and ensure the stability and integrity of the financial system. If they knowingly implement policies that distort credit allocation and endanger the system, it would be ethically problematic as they are neglecting their primary duty.

3. Disregard for consequences: Ethical decision-making involves considering the potential consequences of one's actions. If regulators prioritize their own beliefs over the potential risks and adverse outcomes, it reflects a disregard for the consequences and a failure to uphold ethical principles.

However, it's important to note that assessing professional ethics often requires a deeper understanding of the specific circumstances, motivations, and intentions involved. Additionally, regulatory decisions can be influenced by various factors, such as political pressures or differing interpretations of risks. Therefore, a comprehensive analysis of the situation is necessary to form a definitive judgment on whether the regulators' actions are professionally unethical."

I asked OpenAI:

"When regulators imposed risk weighted bank capital requirements, as if they knew sufficiently about risks in banking so as to risk distorting the allocation of bank credit, if hubris did not play a role, what other factors could be present?"

OpenAI answered:

"While hubris can be one factor that may lead regulators to impose risk-weighted bank capital requirements without acknowledging the potential for distorting credit allocation, there could be other factors at play as well. Here are a few possibilities:

1. Limited information: Regulators might be operating based on the information available to them at the time, which may be incomplete or imperfect. They may genuinely believe they have sufficient knowledge about risks in the banking system, but due to limited data or analysis, they may overlook potential consequences and unintended effects on credit allocation.

2. Regulatory capture: In some cases, regulators may be influenced by industry stakeholders or special interest groups, leading them to implement policies that favor certain institutions or sectors. This can result in regulations that prioritize the interests of specific actors over broader systemic considerations, potentially distorting credit allocation.

3. Political considerations: Regulatory decisions can be influenced by political pressures or considerations. Regulators may face pressure to take action or appear proactive, leading them to implement capital requirements without fully considering the potential impact on credit allocation. Political motivations can sometimes override a thorough and objective assessment of risks.

4. Different interpretations of risks: Regulators may genuinely believe that their understanding of risks is accurate, but their perspectives may differ from alternative viewpoints or dissenting opinions. Differing interpretations of risks can lead to varying approaches to capital requirements, potentially resulting in unintended consequences for credit allocation.

5. Institutional constraints: Regulators operate within institutional frameworks that can shape their decision-making. These frameworks may have inherent biases or limitations that influence the design and implementation of capital requirements, which could inadvertently distort credit allocation.

It's worth noting that these factors are not mutually exclusive, and multiple factors may be present simultaneously. Understanding the specific circumstances, motivations, and dynamics surrounding regulatory decisions is crucial for a comprehensive analysis of the factors involved."

I asked OpenAI:

"Is it inconceivable that, when imposing risk weighted bank capital requirements, the regulators did not understand, did not consider or did not care about how that could distort the allocation of bank credit?"

OpenAI answered:

"While it is difficult to definitively determine the intentions or motivations of regulators, it is not inconceivable that they may not fully understand, consider, or care about how risk-weighted bank capital requirements could distort the allocation of bank credit. Regulatory decision-making processes can be influenced by various factors, and regulators may prioritize certain objectives or overlook potential unintended consequences.

Here are some potential reasons why regulators might not fully understand, consider, or care about the potential distortion of credit allocation:

1. Knowledge limitations: Regulators may lack a comprehensive understanding of the complex dynamics of credit allocation within the banking system. They may have a limited perspective on the potential impacts of their policies and may not fully grasp the intricacies of how risk-weighted capital requirements could affect credit allocation.

2. Incomplete analysis: Regulators might not have conducted a thorough analysis of the potential consequences of risk-weighted capital requirements on credit allocation. This could be due to resource constraints, time limitations, or a failure to consider alternative viewpoints.

3. Other priorities: Regulators may prioritize specific objectives, such as financial stability or capital adequacy, over the potential distortion of credit allocation. They may be more focused on mitigating risks to the overall system rather than considering the potential effects on individual credit allocation.

4. Industry influence: Regulators may face pressure or influence from industry stakeholders or special interest groups. These external influences can shape regulatory decisions and potentially divert attention from considering the distortion of credit allocation.

5. Lack of accountability: Regulatory bodies may operate within a framework that lacks sufficient accountability mechanisms. This can result in regulators not feeling a strong obligation to fully understand or consider the potential consequences of their actions.

It is important to note that the above reasons are speculative and should not be assumed to apply to all regulators in all circumstances. Regulatory decision-making is a complex process influenced by multiple factors, and individual regulators may vary in their level of understanding, consideration, and care regarding the potential distortion of credit allocation caused by risk-weighted bank capital requirements."

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

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

The main causes the so objectionable risk-weighted bank capital requirements are not objected.

A brief summary:

No understanding about what immense hubris “experts” are capable of, like believing they can weigh bank capital requirements for perceived credit risks… and then mostly ignoring misperceived risks and unexpected events e.g., pandemic war.

No understanding of how allowing banks to leverage their capital differently with different assets, will make it easier/harder for banks to obtain the desired risk adjusted returns on equity; something which distorts the allocation of credit.

No knowledge about conditional probabilities; which therefore helps to believe those excessive exposures that could become truly dangerous to bank systems, are built up with assets perceived as risky.

Not understanding that risk-taking is the oxygen of all development.

Consequentially:

No understanding of their pro-cyclicality. When risks are perceived low, credit ratings are high, banks can hold little capital, buy back stock, pay much dividends and bonuses, and so, when times worsen, or something unexpected like a pandemic or a war occurs, banks will stand there naked, precisely when it would be the hardest for them to raise new capital, precisely when we need them the most

No understanding of that since the capital requirements are lower for lending to the “safe” government than to the risky citizens, this implies bureaucrats/politicians know better what to do with (taxpayer’s) credit than e.g., small businesses and entrepreneurs. (Of course, they could also be agreeing with that for pure ideological considerations.)

No understanding of what capital requirements being lower for “safe” residential mortgages than for loans to risky small businesses and entrepreneurs, implies to the possibilities of generating the jobs/incomes needed to service mortgages and pay living costs.

The saddest part is that all these limitations seem to entirely apply to our current Academia. 

How come we ended up with stupid portfolio invariant risk weighted bank capital requirements?

Which are based on:

That those excessive exposures that can really be dangerous to our bank systems are build up with assets perceived as risky and not with assets perceived as safe.

That the bureaucrats/politicians/apparatchiks know better what to do with credit they’re not personally responsible for than e.g., entrepreneurs

That so much of bank capital requirements can depend on the evaluation performed by some very few human fallible credit rating agencies.

That substituting risk adjusted returns on equity for risk adjusted interest rates, would not seriously distort the allocation of bank credit.

Well here is the seed “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules"

And here is Basel Committee’s “An Explanatory Note on the Basel II IRB Risk Weight Functions"

Though Paul A. Volcker, in his autography “Keeping at it”, valiantly confessed “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

And here my explanations:

All bank regulators faced/face a furious attack mounted by dangerously creative capital minimizing / leverage maximizing financial engineers, who, getting rid of traditional loan officers, those with their “know your client” and their “what are you going to use the money for?”, managed to capture the banks. (And, since less capital means less dividends, they can also pay themselves larger bonuses.)

Hubris! “We regulators, we know so much about risks so we will impose risk weighted capital requirements on banks, something which will make our financial system safer” Yep, what’s risky is risky, what’s safe is safe. What is there not to like with such an offer? And the world, for the umpteenth time, again fell for demagogues, populists, Monday morning quarterbacks and those who find it so delightful to impress us rolling off their tongues sophisticated words like derivatives.

In a world full of mutual admiration clubs, like the Basel Committee and Academia in general, you do not ask questions that can imply criticism of any of your colleagues or superiors, “C’est pas comme il faut», nor, if you are a high shot financial journalist, do you risk not being invited to Davos or IMF meetings.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair

Clearly there are many more jobs with ever growing thousands of pages of regulations than with just a one liner: “Banks shall have one capital requirement (8%-15%) against all assets”. And so, instead of getting rid of the extremely procyclical credit risk weighted capital requirements, they designed new insufficient countercyclical ones.

“The time spent on any item of the agenda will be in inverse proportion to the sum involved." Parkinson’s law

Since bank regulators must have heard of (supposedly) Mark Twain’s “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” it is clear they all missed their lectures on conditional probabilities.

“There are some mistakes it takes a Ph.D. to make”, Daniel Moynihan.

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”, George Orwell, in Notes on Nationalism

And so now: 

“A ship in harbor is safe, but that is not what ships are for” John A. Shedd, something that should apply to banks too. Sadly, dangerously our bank systems, banks are overpopulating safe harbors and, equally dangerous for our economy, underexploring risky waters. 

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

And since current bank capital requirements are mostly based on the expected credit risks banks should clear for on their own; not on misperceived credit risks, like 2008’s AAA rated MBS, or unexpected dangers, like COVID-19, now banks stand there with their pants down.

Let us pray 2021 will not be too hurtful.

PS. Might “availability heuristic” “availability bias” help explain these loony risk weighted bank capital requirements?

My 2009 video on the 62.5 times to 1 authorized leverage

My 2019 letter to the Financial Stability Board

My 2019 letter to the Executive Directors and Staff of the International Monetary Fund

I’ve never been a regulator, but on the issue, neither am I a new arrival.

And the regulators’ mumbo jumbo, shows no sign it will stop.

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

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

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

Bank regulators, don’t try now to hide your responsibility for failures behind sophistications. It was pure hubristic ineptitude.

I refer to Andy Haldane’s “The Dappled World” 

Bank regulators don’t try now to sophisticate the reasons you all got it so very wrong. These were very simple.

You did not define the purpose of banks before regulating these.

You ignored to study why banks fail and kept to why bank assets fail, which of course is pas la meme chose.

You ignored that banks look to maximize their risk-adjusted returns on equity, before distorting the allocation of bank credit with your risk-weighted capital requirements for banks.

You ignored the monstrous systemic risks that putting so much decision power into the hands of so human fallible credit rating agencies implied.

You imposed you statist ideological preferences with the risk weights of 0% for the Sovereign, and 100% for We the People.

No! Anyone who has ever walked on main-street, and seen the difficulties those perceived as risky have in accessing bank credit would have understood how loony these regulations were. Frankly, you do not have to be a PhD for that 

When it comes to discrimination, EU cares more about the access to a monastery than about the access to bank credit

If I had the right to vote I would have voted for Britain to stay in EU. But I would have hoped for that this option had won by just one vote, so that there was huge pressure on EU to clean up its act. It sorely needs it.

For instance, the European Commissioner for Internal Market and Services is in charge of promoting free movement of capital and therefore has a lot do to with the extremely important area of regulating the financial services. 

It is a topic of much interest for me since, for more than a decade, I have argued that the Basel Committee’s risk weighted capital requirements for banks, is impeding the free movement of capital with disastrous consequences for the real economy.

But in 2012, during a conference in Washington by the then Commissioner Michel Barnier, I was handed a brochure that presented, as a success story of his office, the following: 

“A French citizen complained about discriminatory entry fees for tourists to Romanian monasteries. The ticket price for non-Romanians was twice as high as that for Romanian citizens. As this policy was contrary to EU principles, the Romanian SOLVIT centre persuaded the church authorities to establish non-discriminatory entry fees for the monasteries. Solved within 9 weeks."

And then I knew for sure something smelled very rotten in the EU, with its full of hubris besserwisser not accountable to anyone technocrats.

How can they waste time on such small time discrimination when those borrowers ex ante perceived as risky, and who therefore already got less bank credit and at higher interest rates, now suffer additional discrimination caused by regulators requiring banks sot hold more capital when lending to them that when lending to those ex ante perceived as safe? And on top of it all, for absolutely no reason, since dangerous excessive bank exposures, are always built up with assets perceived as safe.

Barnier, as Frenchman should know Voltaire’s “May God defend me from my friends: I can defend myself from my enemies.” But now bank regulators tell banks “trust much more your friends”, the AAA rated, and to which in Basel II they assigned a risk weight of 20%; and “beware even more of your enemies”, the below BB- rated, and which were given a risk weight of 150%.

As a result banks can leverage more their equity with “safe” assets than with “risky” assets, and so they now earn higher risk adjusted returns on equity when lending to sovereigns, members of the AAArisktocracy or financing houses, than when lending to SMEs and entrepreneurs.

And as a direct consequence of this regulatory risk aversion, banks do not any longer finance the riskier future, they only refinance the for the short time being safer past.

So there is no wonder EU is not doing well. And if Brexit helps to push for the reform that are needed, then Britain should be given an open invitation to return to it at its leisure.

PS. During the Washington conference I just could not refrain from asking what the French citizen did for 9 weeks while waiting for SOLVIT to come to his rescue.

PS. Lubomir Zaoralek the minister of foreign affairs of the Czech Republic in FT “Europe’s institutions must share the blame forBrexit” July 1. Hear hear!

John D. Turner’s “Banking in Crisis” truly evidences a mind-blowing "Regulations in Crisis"

Turner writes: “If the rationale of bank regulation is to prevent banks from risk shifting and the banking system from collapsing, then the Basel approach to capital regulation failed dramatically”

That might seem like a correct statement but it is not. The true rationale of bank regulations is to assure banks serve their social and economic purpose of allocating bank credit to the real economy, without of course incurring excessive risks that could lead to the collapse of the banking system.

And in this respect the Basel approach, as it completely ignored that purpose of banks, and even went so far as to de-facto base its prime pillar, the risk-weighted capital requirements, on distorting the allocation of credit, fails even more dramatically.

Turner writes: "One reason for this failure was regulatory arbitrage… whereby capital regulations perversely incentivized banks to become riskier”

Absolutely wrong! The capital regulations perversely incentivized banks to create dangerous large exposures to what was perceived or deemed to be safe”

Turner writes: "Indeed, much bank lending to the residential-property market could have been partially due to the regulatory arbitrage because such lending had a 50 percent weighting in a Basel risk-weighted asset calculation, compared to 100 per cent for a commercial loan”

What regulatory arbitrage? Regulator set the weights that allowed banks to leverage twice as much on residential-property market loans than on commercial loans. Banks did not arbitrage, they did what they were instructed.

Turner writes: "To increase their return on equity, banks engaged in ’cherry-picking’ by shifting the composition of their loan portfolios towards riskier credits.”

What? In order to increase their expected risk-adjusted returns on equity they shifted the composition of their loan portfolios towards those credits that perceived or deemed as safer, allowed them to hold less capital. That is NOT ’cherry-picking’, that is something healthy banks are supposed to do to remain healthy, or does Turner believe it is good banks should on purpose try to lower their risk-adjusted returns on equity?

Of course with this type of regulations, there was much vested interest in hiding the risks. The pressures on the credit rating agencies to provide Potemkin AAA ratings were immense.

No! This current bunch of regulators, trying to avoid their own mental monsters, confusing ex ante risk with ex post realities, have distorted all common sense out of the allocation of bank credit. And so now banks no longer finance the riskier future they just keep on refinancing the for the time being safer past.

Our children and grandchildren will pay for their hubris.

The risk-weighted capital requirements clear in the capital for risks that have already been cleared for by means of risk premiums and size of exposures. And any perceived risk, even if perfectly perceived, if excessively considered, guarantees wrong actions.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

And regulators also forgot that even the safest harbors could turn into dangerous traps, if excessively populated.

We must completely clean the bank regulatory slate, which of course begins with retiring all current regulators who are suffering from the credit risk adverse Basel frame of mind.

PS. All the discussion here were limited to pages 195-199 of John D. Turner's "Banking in Crisis" 

Before blaming any regulatory capture on bankers, look first to the parents of central bankers and regulators.

That is because the regulatory capture could very well begin with some overly sissy parents, whose risk-adverseness causes the risk aversion in their kids which makes them natural candidates to be central bankers and regulators.

And then their grown-up equally scared kids, prohibit banks from engaging in natural market risk-taking, like lending to entrepreneurs and start-ups. 

And that risk-adverseness takes the strength out of the real economy, and, at the end, only causes banks to take truly dangerously excessive risks on what regulators, with amazing hubris, consider themselves to be capable to deem as “absolutely safe”… like the infallible sovereigns (Greece), the AAAristocracy (securities collateralized with mortgages to the subprime sector) or real estate (Spain).