#AI ChatGPT: What makes more sense, bank capital requirements based on unexpected risks or on perceived risks?

I asked ChatGPT:

"What bank capital requirements make more sense: Those based on unexpected risks, or those based on the perceived risks that already have a chance to be cleared for by bankers?

Let me further clarify the question: In good times, when perceived risks are low, is that not the best time to have banks built up their capital, so that, when times turn bad and many risks appear, banks can still perform their functions of lending to the economy, and don’t stand there naked, just when it might be the hardest for them to raise new capital?"

ChatGPT answered: 

"Both approaches to bank capital requirements have their merits, but in general, capital requirements based on unexpected risks tend to make more sense and are considered more effective in promoting financial stability.

Unexpected risks-based capital requirements: These capital requirements are designed to account for potential risks that may not be immediately evident or may not have been factored into the initial risk assessment. The advantage of this approach is that it ensures banks have sufficient capital buffers to weather unforeseen events, such as severe economic downturns, financial crises, or unexpected systemic shocks. By having capital reserves to cover unexpected losses, banks are better equipped to maintain their lending activities during challenging times.

The unexpected risks-based approach is also more forward-looking and takes into account the inherent uncertainty in the financial system. This means that banks are better prepared for adverse scenarios, and regulators can take preemptive action to address emerging risks.

Perceived risks-based capital requirements: Perceived risks refer to the risks that are already known and accounted for in the risk models used by banks and regulators. These capital requirements are typically based on historical data and past performance. While they provide some level of risk management, they may not fully capture the potential impact of future risks or systemic events.

The main concern with relying solely on perceived risks-based capital requirements is that they may not adequately account for tail events or extreme situations. In times of economic prosperity or when perceived risks are low, banks might be inclined to operate with lower capital levels, which could leave them vulnerable when unexpected risks materialize.

In summary, a balanced approach to bank capital requirements is essential. Unexpected risks-based capital requirements are critical for ensuring banks can withstand severe shocks and continue to function during economic downturns. Additionally, such requirements promote a more resilient financial system and reduce the likelihood of a financial crisis. On the other hand, perceived risks-based capital requirements still play a role in managing known risks, but they should not be solely relied upon, as they may not fully address the potential impact of unanticipated events. Ultimately, a combination of both approaches can help strike the right balance between financial stability and supporting economic growth."

Note: After this question to ChaGPT and its answer I wrote “Thanks!”

ChatGPT answered “You're welcome! If you have any more questions or need further clarification on any topic, feel free to ask. Happy learning!” :-)

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

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

#AI #OpenAI #ChatGPT #Grok: Should risk weighted bank capital requirements consider conditional probabilities?

I asked ChatGPT:

"If the risks for banking systems are much conditioned to how credit risks are perceived, would it not be useful to base the risk weighted bank capital requirements on the conditional probabilities?"

ChatGPT answered:

"Yes, incorporating conditional probabilities into risk-weighted bank capital requirements could provide a more accurate and nuanced assessment of credit risks. By considering conditional probabilities, the regulatory framework could account for the specific characteristics and circumstances that affect the likelihood of default or other credit events.

Conditional probabilities take into account the probability of an event occurring given that another event has already happened. In the context of credit risk, this means considering the probability of default or credit deterioration given specific credit rating categories or other relevant factors.

By utilizing conditional probabilities, regulators could tailor risk weights more precisely to reflect the true credit risk associated with different assets. This approach could help mitigate the potential for misalignment between risk weights and actual risk, which is important for maintaining the stability and soundness of the banking system.

It's worth noting that while incorporating conditional probabilities could enhance the accuracy of risk assessment, it may also increase complexity and require a more robust data infrastructure to gather and analyze the necessary information. Additionally, the challenge lies in establishing a reliable and consistent framework for determining conditional probabilities across various credit risk scenarios.

Regulatory frameworks like Basel III have introduced more sophisticated approaches, such as stress testing and the use of internal models, to better capture credit risk. While these frameworks may not explicitly employ Bayesian methods, they aim to improve the risk sensitivity of capital requirements and align them more closely with the underlying credit risks faced by banks.

In summary, incorporating conditional probabilities into risk-weighted bank capital requirements could be beneficial for a more precise assessment of credit risks, but it would require careful consideration of data, modeling techniques, and the overall complexity involved."

As part of a recent dialogue with Grok 4 I said:

“Of course, AI can be helpful. Imagine if many decades ago it would have been able to recommend to the Basel Committee that when decreeing their risk weighted bank capital requirements, they should not ignore the Bayesian conditional probabilities.”

Grok commented:

 

"You’re spot-on that AI could have been a game-changer for the Basel Committee decades ago, particularly by highlighting the importance of Bayesian conditional probabilities. 

Basel’s risk-weighted capital requirements (RWAs) rely on static risk weights (e.g., 0% for sovereigns, 100% for corporates), which ignore how risks interact dynamically. Bayesian methods, which update probabilities based on new evidence, could have exposed flaws in assuming assets like AAA-rated mortgage-backed securities (MBS) were inherently "safe." For instance:

Conditional Risks: A Bayesian approach might have flagged that the "safety" of AAA-rated MBS depended on housing prices not collapsing—a condition that wasn’t guaranteed. In 2007, few models accounted for correlated defaults across mortgage pools, a blind spot AI could have illuminated.

 

Dynamic Updating: AI trained on historical data could have warned that low default rates on mortgages pre-2008 were skewed by a credit boom, not structural safety, adjusting risk estimates as conditions changed.

 

A 2019 study in Journal of Financial Stability noted that machine learning models, incorporating Bayesian techniques, outperformed traditional risk models in predicting systemic banking crises by capturing non-linear dependencies. 

Had the Basel Committee used such tools in the 1980s or 1990s, they might have designed more robust rules, avoiding the overconfidence in “safe” assets that you’ve critiqued. AI could still play this role today—advising regulators to stress-test assumptions and prioritize dynamic risk signals over rigid categories. But, as you imply, it’s a tool, not a replacement for human judgment or market mechanisms."

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

PS. https://subprimeregulations.blogspot.com/2018/08/risk-weighted-capital-requirements-for.html

Bank regulators, please wake up, being more creditworthy, should not mean, as you have decreed, being also deemed more worthy of credit.

Anyone deemed more creditworthy in terms of representing less risk of default will, by definition, get more credit and on better terms (like lower risk adjusted interest rate) than anyone deemed to be less creditworthy.

But if banks are allowed to leverage their equity more with the more creditworthy, and can so easier earn higher risk adjusted returns on equity, that does also imply these borrowers to be more worthy of credit than the less creditworthy… and that’s as wrong and dangerous as can be, for the bank system and for the real economy... and in reality, that's even immoral.

The wealthy are usually creditworthy, but they not more worthy of credit than the “riskier” poor. The risk weighted bank capital requirements, wrongly and immorally, Decreed Inequality.

A government is (at least in the short run) quite often very creditworthy, but it is not more worthy of credit than its citizens, as the risk weighted bank capital requirements so wrongly decree.

A house buyer is often creditworthy, but he is not more worthy of credit than e.g., small businesses and entrepreneurs, as  the risk weighted bank capital requirements so wrongly decree.

A house buyer with a larger down-payment, a lower loan to value LTV, is more creditworthy, but he is not more worthy of credit than a riskier house buyer providing a smaller down-payment, a higher LTV, as the risk weighted bank capital requirements so wrongly decree.

A developed nation is (at least in the short run) quite often very creditworthy, but it is not more worthy of credit than riskier developing nations, as the risk weighted bank capital requirements so wrongly decree.

A federal government is (at least in the short run) quite often very creditworthy, but it is not more worthy of credit than riskier local governments, as the risk weighted bank capital requirements so wrongly decree.

An AAA rated corporation is credit creditworthy, but it is not more worthy of credit than a much riskier below BB- rated one, as the risk weighted bank capital requirements so wrongly decree.

And I could go on and on

What would America's Founding Fathers say?

My 2019 letter to the Financial Stability Board FSB

 

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

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

My letters on our so mistaken bank regulations that have been published by the Washington Post. Thanks WP!

September 6, 2007: Factors in the Financial Storm

June 20, 2008: An Aspect of the Bubble

December 27, 2009: Another 'worst': Faulty bank regulation

January 6, 2012: Handcuffed by a triple-A rating 

May 1, 2013: An American approach to banking

December 23, 2014: Let the market rule on risky trades

November 11, 2015: Reverse-mortgaging the future

August 9, 2016: Banks, regulators and risk

April 16, 2017: When banks play it too safe 

July 11, 2018: There is another tariff war that is being dangerously ignored. 

December 30, 2018: Affordable homes or investment assets?

ECB’s Sabine Lautenschläger explains why the risk weighted capital requirements for banks is total lunacy but, unfortunately, not even she hears it.

I quote the following from ECB’s Sabine Lautenschläger’s speech on February 15, 2018, “A stable financial system – more than the sum of its parts” 

“Logic can be a tricky thing. Apply it in the right way, and you always arrive at a consistent conclusion. But apply it in the wrong way, and it can lead you astray. And that happens all too easily. There are indeed many wrong ways in which we can apply logic.”

One of them is known as the fallacy of composition. It refers to the idea that the whole always equals the sum of its parts. Well, that idea is wrong. As we all know, the whole can be more than the sum of its parts – or less.

Consider this statement: if each bank is safe and sound, the banking system must be safe and sound as well. By now, we have learnt the hard way that this might indeed be a fallacy of composition.

Let me give you just one example. Imagine that a certain asset suddenly becomes more risky. Each bank that holds this asset might react prudently by selling it. However, if many banks react that way, they will drive down the price of the asset. This will amplify the initial shock, might affect other assets, and a full-blown crisis might result. Each bank has behaved prudently, but their collective behaviour has led to a crisis.

The business of banking is ripe with externalities, with potential herding and with contagion. These factors may not be visible when looking at individual banks, but they can threaten the stability of the entire system. This is one of the core insights from the financial crisis.”

Let me comment on the implications of this quite lengthy quotation: 

First: “a certain asset suddenly becomes more risky” That means that the real problem is that it was perceived as safer before.

Second: “The business of banking is ripe with externalities, with potential herding and with contagion.” There can be no doubt that potential herding” is much mote likely to occur with assets perceived as safe.

So what is Sabine Lautenschläger really saying with all this? That the current risk weighted capital requirements, Pillar 1, more perceived risk more capital – less perceived risk less capital, is sheer lunacy, though she might not understand it. 

The truth is that the real logic, not that pseudo logic applied by bank regulators, is that the safer an asset is perceived, the greater the potential danger to the bank system it poses.

Lautenschläger also said: “Imagine that there is a downturn in the financial cycle. From the viewpoint of each bank, credit risks increase and microprudential supervisors may want to increase Pillar 2 capital demands. Looking at the same trend, macroprudential supervisors might want to support credit growth and counter the cycle over a longer time horizon and from a systemic point of view. Thus, they may want to decrease Pillar 2 capital demands.”

“credit risks increase” That goes in the direction from safer to riskier. Does going from riskier to safer pose any danger? No!

So is not assigning the lowest capital requirements to what is ex ante perceived as safe just the mother of procyclical regulations, or in other words, the mother of all macroprudential imprudences? 

Ex post dangers are a function of ex ante perceptions. The safer something is perceived the more real danger it poses. The riskier something is perceived, the less harm it can cause.

How on earth could one expect a good application of Basel Committee’s Pillar 2 (Supervisory Review Process) from those who are messing it all up with a so faulty Pillar 1?

Recommendation: Ask a regulator: “What is more dangerous to the bank system, that which is perceived risky or what is perceived safe?” If he answers, the “risky”, ban him from regulating banks.

My tweets asking very courteously bank regulators for an explanation

Dear bank regulators, please explain your current risk weighted capital requirements for banks against these four scenarios:

1. Ex ante perceived safe – ex post turns out safe - "Just what we thought!"
2. Ex ante perceived risky – ex post turns out safe - "What a pleasant surprise! That's why I am a good banker"
3. Ex ante perceived risky – ex post turns out risky - "That's why we only lent little and at high rates to it."
4. Ex ante perceived safe – ex post turns out risky - "Now what do we do? Call the Fed for a new QE?"

Because, as I see it, from this perspective, your 20% risk weights for the dangerous AAA rated, and 150% for the so innocous below BB- sounds as loony as it gets.

Here are some of my current explanations of why I believe the risk weighted capital requirements for banks are totally wrong.

And below an old homemade youtube, published September 2010, on this precise four scenarios issue

Here is conclusive evidence of that current bank regulation experts, dangerously, do not know what they are doing

The risk-weight the regulators assigned in Basel II to those corporates (private sector) rated AAA to AA was 20%; and to those rated below BB- one of 150%

That might have been a correct reflection of the ex ante risks of the AAA to AAA and the below BB- rated failing but, it is definitely not the risk for banks conditioned on the bankers having seen and acted upon those perceived risks.

That is: what are the real risks considering the risks that are perceived?

That is: motorcycles are very risky, that’s why so many more people die in accidents of the safer cars.

That is: clearly the below BB- rated do not pose danger for the banking system while the AAA to AA rated to which banks could build up excessive exposures definitely do.

In other words the bank regulators assumed bankers did not perceive credit risks at all, that bankers were totally blind, and so that they, the regulators, had to shoulder that whole responsibility.

That completely distorted the allocation of bank credit to the real economy, something that represents huge dangers for the banking system and for the health of the rest of the real economy.

This amazing incompetence of the regulators, mostly of the Basel Committee and the Financial Stability Board, has remained unquestioned by most experts. Could that be because they are all suffering from an excessive confidence in fellow experts, or could it be because of what John Kenneth Galbraith once said: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”?

You tell me!

PS. Here a more extensive aide mémoire on the horrors of current risk weighted capital requirements for banks

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?

Basel Committee’s mindboggling naiveté: Banks, thou shall not misbehave and fudge to lower your capital requirements

In the “Statement on capital arbitrage transactions” Basel Committee newsletter No 18 of June 2016 we read:

“Transactions that are designed to offset regulatory adjustments employ a variety of strategies. For example, these may include: (1) the issuance of senior or subordinated securities with or without contingent write off mechanisms; (2) sales contracts that transfer insufficient risk to be deemed sales for accounting purposes; (3) fully-collateralised derivative contracts; and (4) guarantees or insurance policies. These types of transactions… can have the effect of overestimating eligible capital or reducing capital requirements, without commensurately reducing the risk in the financial system, thus undermining the calibration of minimum regulatory capital requirements.

Banks should therefore not engage in transactions that have the aim of offsetting regulatory adjustments.”

What a mindboggling naiveté! While regulators allow banks to hold less capital against assets perceived, decreed or concocted as safe, and the risk-adjusted return on equity is how banks compete for capital (and bonuses), how can they think banks will not do their utmost to lower the required equity?

PS. Children, listen to your Basel nannie, though there is ice-cream and chocolate cake in the fridge, she still expects you to eat the spinach and the broccoli.

PS. You want your children not to arbitrage and eat of everything... blend it all together.

PS.You want your banks not to arbitrage... set one capital requirements for all assets.

The Basel Committee’s besserwissers, on top of the ordinary defenses of banks, built a dangerous Maginot Line,

When banks use ex ante perceived credit risks (EAPCRs) to determine the interest rates (risk premiums) the amounts and other contractual terms of their exposures… all these their defenses, it might still at the end of the day, at least for some individual banks, end up like a totally useless Maginot Line.

But, when regulators decide to base their capital requirements for banks on precisely the same EAPCRs, then they are, de facto, on top of the defenses built by the bankers, building an extremely dangerous Maginot Line that could bring the whole banking system down.

That is because giving 200% weight to the EAPCRs will mean that “The Safe” be perceived as safer than what the EAPCRs validate, and “The Risky” will be perceived as riskier than the EACPRs validate. And the banking system will therefore lend too much to The Safe ("infallible sovereigns" and AAArisktocracy) and too little to The Risky (SMEs and entrepreneurs.

God make us daring!

God save us from hubristic besserwisser regulators’ mumbo jumbo scheming!

The only moment when we currently could deem our banks to be safe, and the credit allocation to the real economy is not distorted, is when the EAPCRs are adequately wrong. Meaning The Safe are in reality safer than perceived; and The Risky are in reality riskier than perceived… What a crazy world!

PS. May I humbly remind you of The Per Kurowski’s Rule?

Fair and equitable growth has been made impossible by current bank regulations.

Even though banks already take into consideration the perceived credit risks when setting their interest rates and amount of exposure the regulators also use exactly the same perceived risk when setting the capital requirements.

And that means the banks’ sensitivity to perceived credit risk, is multiplied by two.

So what is perceived as safe will now mean doubly perceived as safe, and so it will have even more access to bank credit; and what is perceived as risky will now mean doubly perceived as risky, and so it will have even less access to bank credit.

How on earth can you have fair and equitable growth with such regulations?

The world’s banking system has been instructed by its regulator to give perceived credit risk a 200% weighting.

With bankers using perceived credit risk to set their interest rates and amount of exposures; and regulators using the same perceived credit risk to set their capital requirements for banks; it is clear that perceived credit risks get a 200% weighting. 

Any banking system that becomes 200% sensitive to perceived credit risks, dooms itself to lend dangerously much to The Safe, the Infallible Sovereigns and the AAArisktocracy; and way too little to The Risky, like to SMEs and entrepreneurs; which is of course fatal for the real economy and therefore also to the banks.

What would have happened if Winston Churchill, when confronted with the dangers had said: "In order to avoid our houses being bombed, we need to become 200% sensitive to risk."

This whole blog is dedicated to explaining how fatally flawed current Basel Committee originated bank regulations are. Here is a recent public letter to its current chair Mr. Stefan Ingves.

Here is what those who believe risk weighted capital requirement for banks is smart must be thinking.

Are you one of them?

The pillar of current bank regulations is risk weighted capital requirements for banks: More perceived credit risk more capital – less perceived credit risk less capital.

Below what those who believe risk weighted capital requirement for banks is smart, must be thinking. Are you one of them?

That though with banks so many other aspects are risky, like the possibility of cyber attacks, the only thing that matters are credit risks.

That even though banks perceive credit risks, and adjust for that with risk premiums and the size of their exposures, that’s not enough, banks must also adjust for the same perceived risks in their capital.

That lending little at high-risk premiums to something perceived risky, is riskier than lending a lot at very low risk premiums to something perceived safe.

That bankers, no matter what Mark Twain thinks, love to lend out the umbrella when it rains and abhor doing so when the sun shines.

That it is the specific credit risk of the assets that matter, and not how banks manage those risks.

That the expected credit risks are good estimators of the unexpected losses banks need to hold capital against.

That the safer an asset is perceived the less is its potential to deliver unexpected losses.

That the riskier and asset is perceived the greater is its potential to deliver unexpected losses. 

That as long as banks do not fail, the rest, like if they allocate bank credit efficiently to the real economy or not, does not matter. 

That even though a bank is required to hold more capital lending to someone perceive risky than when lending to the AAArisktocracy, that has nothing to do with inequality.

That even if a sovereign depends on its citizens, the sovereign can have a zero risk weight while the citizens, like SMEs and entrepreneur should have a 100 percent risk weight.

That though all major bank crises have occurred because of excessive exposures to what was erroneously perceived as safe, that has nothing to do with tomorrow's bank crises.

That even though no major crisis has have occurred because of excessive exposures to what ex ante was perceived as risky, that has nothing to do with tomorrow's bank crises.

That if you, to the banker’s natural risk aversion, add on the regulators natural risk aversion, you will not risk getting an excessive risk aversion that could be dangerous for the real economy.

That if the perceived credit risk is correct, it does not matter how much importance you give to that perception.

That if you play around with the odds of roulette it will survive as a viable game

How to blow up the banking system

Q. What is the most dangerous for banks?

A. That they build up excessive dangerous exposures to something that turns out much riskier than they expected

Q. When do banks usually build up such exposures?

A. Obviously when they perceive something as very safe and they expect to make very good returns on it.

Q. And what else can make those excessive bank exposures especially dangerous, for instance for the taxpayers?

A. That the banks, if something goes wrong, stand there almost naked with very little equity to cover the losses.

Q. So hypothetically, mind you, what would you think of credit-risk weighted capital requirements for banks that are especially low for what is perceived as safe?

A. Well, since that would allow banks to earn the highest risk adjusted returns on what is perceived as safe, it would therefore, sooner or later, cause banks to build up dangerously excessive exposures to what is perceived as safe against very little capital, and so it sure sounds like the perfect way to blow up the banking system..... Sir, excuse me, why do you ask all this?

PS. 1999 in an Op-Ed I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause it collapse”

Note: My January 2009 AAA-Bomb blog

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?

Where could truly dangerous really unexpected events occur the most?

REALLY UNEXPECTED? THINK IT THROUGH?

Bank capital is to be held against unexpected losses because the expected losses derived from the perceived risks are already cleared for by smaller exposures and higher risk premiums,

The Basel Committee for banking supervision considered the dangerous looking forest had the greatest potential of the unexpected...

and therefore decided to require banks to hold the greatest capital when entering the dark scary forest (with its expected risks) than when entering that beautiful field (with its little expected risks).

Smart or extremely dumb?

Extremely dumb no doubt: That's why banks loaded up on what was perceived as safe, like AAA rated securities, like loans to Spanish real estate, like loans to the government of Greece... and do not give loans to those "risky" SMEs and entrepreneurs... who can help or economies to move forward, in order not to stall and not to fall.