#AI ChatGPT – OpenAI: What if roulette paid out more than what odds merited on “safe” bets and less so with “risky” bets?

I asked OpenAI:

"What would happen to a casino if their roulette game paid out more than what odds merited on “safe” bets, like colors, and paid out less than what odds merited on “risky” bets, like numbers?"

OpenAI answered: 

"If a casino intentionally set up their roulette game to pay out more than the odds merited on "safe" bets, such as colors, and paid out less than the odds merited on "risky" bets, like numbers, it would be a highly unusual and unsustainable practice. Let's explore the potential consequences:

1. Initial Attraction: Initially, such a casino might attract more players who are enticed by the higher payouts on the "safe" bets. This could result in increased footfall and activity, as people perceive it as an opportunity to earn more.

2. Imbalanced Payout Structure: However, the imbalanced payout structure would create a significant advantage for the players on "safe" bets. Over time, the casino would start losing money on these bets. The casino's profits would heavily depend on players consistently making "risky" bets, where the odds are unfairly skewed against them.

3. Unsustainability: The casino's profitability would likely suffer in the long run due to the imbalanced payout structure. Skilled or knowledgeable players would realize the advantageous odds on "safe" bets and exploit them, while the allure of the lower odds on "risky" bets would eventually wane.

4. Reputational Damage: Operating a casino with a flawed payout system could result in significant reputational damage. Players would quickly recognize the unfairness and feel cheated. Word would spread, and the casino's credibility and trustworthiness would be severely compromised, leading to a loss of customer loyalty.

5. Regulatory and Legal Consequences: Casinos are subject to strict regulations and oversight. Intentionally manipulating payout odds could be considered fraudulent or illegal, depending on the jurisdiction. The casino could face legal consequences, fines, or even lose its license to operate.

6. Competition and Market Impact: In a competitive gambling industry, other casinos would likely capitalize on the opportunity to criticize and attract players away from the casino with the imbalanced payout system. They could emphasize fair odds and better player experiences, further eroding the imbalanced casino's market share.

In conclusion, intentionally setting up a roulette game with imbalanced payouts would likely lead to short-term gains followed by long-term losses, reputational damage, and potential legal consequences. Casinos typically operate based on the principle of providing games with fair odds and a built-in house edge to ensure profitability over time.

I asked OpenAI:

"Is that situation not somewhat similar to when regulators, with risk weighted bank capital requirements, allow banks to leverage their equity more with bets on what’s perceived as safe and thereby easier obtain higher payouts on equity, than with bets on what’s perceived as risky?"

OpenAI answered:

"Yes, you are correct that there is a similarity between risk-weighted bank capital requirements and the potential for banks to leverage their equity more with perceived "safe" bets. Let's delve into this further:

1. Risk-Weighted Capital Requirements: Risk-weighted bank capital requirements are designed to incentivize banks to allocate more capital for riskier assets. This means that banks must hold a higher amount of capital relative to the risk associated with a particular asset or exposure. The risk weights are typically determined by regulatory authorities based on the perceived riskiness of different types of assets.

2. Leverage and Payouts: When banks hold more capital against riskier assets, it effectively limits their ability to leverage their equity and increases the amount of capital they need to set aside. Consequently, banks have less leverage available to amplify potential gains or payouts on those riskier assets.

3. Perceived Safety and Higher Payouts: On the other hand, if regulators deem certain assets or exposures as less risky, they assign lower risk weights. This allows banks to hold less capital against those assets, enabling them to have higher leverage and potentially obtain higher payouts on their equity. This can be seen as an incentive for banks to allocate more resources towards assets perceived as safer.

4. Risk-Return Tradeoff: The risk-weighted capital requirements acknowledge the risk-return tradeoff inherent in banking activities. By allowing banks to leverage more on perceived safer bets, regulators aim to create a balance that encourages prudent risk management. Banks have the potential to generate higher returns on their equity from these safer bets, but with relatively lower risk.

It is important to note that risk-weighted capital requirements are part of a broader regulatory framework aimed at maintaining financial stability and safeguarding the banking system. Regulators continuously evaluate and adjust these requirements based on evolving market conditions and risk assessments.

While there are similarities to the casino example in terms of leveraging equity differently based on perceived risk, the motivations and implications in the banking sector are fundamentally different due to the importance of financial stability, prudential risk management, and systemic considerations.

I asked OpenAI:

With respect to obtaining profits without compromising the security of their entity, how do the motivations between casino owner and bank owners differ?

OpenAI answered:

"The motivations of casino owners and bank owners differ significantly due to the nature of their respective industries and the role they play within the economy. When it comes to obtaining profits without compromising the security of their entities, the motivations can be understood as follows:

1. Casino Owners: Casino owners primarily operate within the entertainment and gambling industry. Their motivation is to generate profits by offering various games and attractions to customers. However, casinos operate under the understanding that the odds are in their favor in the long run. They design their games to have a built-in house edge, ensuring that they are statistically likely to make money over time. The profitability of a casino depends on a consistent flow of customers who participate in games and, on average, lose more money than they win. Casino owners strive to strike a balance between providing an enjoyable experience to customers and maintaining profitability.

2. Bank Owners: Bank owners operate within the financial sector and provide various banking services such as accepting deposits, making loans, facilitating transactions, and offering investment products. Their primary motivation is to generate profits while managing risk. Banks make money through the interest charged on loans, fees for services, and returns on investments. However, their profitability is not solely dependent on customer losses but rather on effective risk management, prudent lending practices, and diversification of their operations. Banks have a fiduciary responsibility to protect customer deposits and maintain the stability of the financial system. Their motivations are driven by long-term sustainability, maintaining regulatory compliance, and building trust and confidence among their customers and stakeholders.

In summary, while both casino owners and bank owners seek profitability, their motivations and the ways they achieve profits differ significantly. Casino owners rely on the inherent odds in their favor, whereas banks aim to generate profits through a range of financial services while managing risks and maintaining the security and stability of their entities."

My comment: Artificial Intelligence here seems with certainty opine casino owners love profits much more than what bankers do. I guess AI could be helped by relying a bit more on Human Intelligence / Intuition.

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

PS. Not the first time I have dwelt on this issue.

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

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

PS. Here is a current summary of why the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?