AI ChatGPT – Grok: Do the risk weighted bank capital requirements amplify the difference in interest rates between developing countries and developed nations?

United Nations - Human Rights: 1986 -Declaration on the Right to Development

I asked ChatGPT:

Answer Yes or No. "The difference between the interest rates developing countries and developed nations need to pay when borrowing, is that amplified by the risk weighted bank capital requirements?"

ChatGPT answered: Yes.

I said: Thanks!

It replied: You're very welcome!

I asked Grok: 

Answer Yes or No. "The difference between the interest rates developing countries and developed nations need to pay when borrowing, is that amplified by the risk weighted bank capital requirements?"

Grok answered:

"Yes. Basel risk-weighted capital rules assign materially lower (often zero) risk weights to highly rated developed-country sovereign exposures than to lower-rated developing-country ones. Banks must therefore hold more capital against the latter, raising the all-in cost of holding or extending that debt and widening the observed interest-rate spread beyond the pure credit-risk premium."

I asked Grok: 

“What if risk weights were equal for all countries?”

Grok answered:

“Equal risk weights would remove the regulatory amplifier of sovereign spreads, so the gap between what developed and developing countries pay would shrink toward the pure market premium for credit, liquidity, and currency risk.

Under the current Basel framework, exposures to highly rated sovereigns (typically developed countries) often carry a 0 % risk weight, while lower-rated sovereigns (typically developing countries) carry 20–150 % depending on the external rating bucket. Banks therefore need less (or zero) capital to hold the former and more capital to hold the latter. That capital charge is passed into higher required yields on developing-country debt.

If every sovereign exposure carried the same risk weight:

Banks would no longer receive a capital advantage for preferring developed-country paper. Demand for developing-country bonds would rise relative to the status quo (or demand for developed-country bonds would fall), narrowing yield spreads.

The remaining differential would reflect only what private investors price—default probability, recovery, liquidity, and exchange-rate risk—without the discrete regulatory step-up.

The size of the change would depend on the common weight chosen. A flat 0 % weight would cheapen developing-country borrowing the most but leave banks with no capital buffer against sovereign losses. A flat positive weight (for example 20 % or 100 %) would raise funding costs for today’s zero-weight sovereigns and reduce overall bank balance-sheet capacity.

Domestic-currency sovereign holdings, which many jurisdictions already zero-weight by national discretion, would lose that preferential treatment if the rule were applied uniformly; home-bias in bank portfolios would weaken.

Empirical work on Basel II/III implementation and on proposed “sovereign floor” reforms finds that rating-based risk-weight differentials contribute several tens of basis points to emerging-market spreads, especially in the BBB-and-below buckets. Equalizing the weights would eliminate that component. It would not eliminate spreads entirely, nor would it remove other frictions (capital controls, index eligibility, dealer balance-sheet constraints). It would also shift more of the risk-bearing decision from regulators’ rating maps onto banks’ own assessments and onto market prices."

I said: Thanks!

It replied: You're welcome.

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

#AI ChatGPT – Grok: Multilateral development banks’ help, investments or loans, what aligns best the incentives?

 I asked ChatGPT: Briefly please. Around 200 words.

“If the multilateral development banks’ help came in form of investments to be paid back through dividends at a somewhat higher rate than what they would have charged on their loans, could that align better the incentives for both sides?”

ChatGPT answered:

"Yes, in many cases it could align incentives better than traditional sovereign lending.

When multilateral development banks such as World Bank, International Finance Corporation or Inter-American Development Bank provide loans, they are largely protected as creditors. They get repaid first, often regardless of whether the financed projects truly generate sustainable growth. That can weaken discipline on both sides: borrowers may overborrow, while lenders may emphasize loan volume over long-term productivity.

If support instead came more through equity-like investments paid back via dividends, incentives would become more symmetric. The development bank would earn more only if the investment genuinely succeeded and generated economic returns. That would encourage greater scrutiny of project quality, governance, transparency, and efficiency before committing funds. Borrowing countries, meanwhile, would face less pressure from fixed debt-service obligations during downturns, reducing the risk of debt crises.

Such arrangements could also encourage MDBs to focus more on enabling productive private-sector activity rather than financing politically attractive but economically weak projects.

However, there are tradeoffs. Governments may resist sharing upside returns or perceived foreign influence over strategic assets. MDBs would also face higher risks, more volatile income, and potentially political criticism if investments fail.

Still, a system with more “shared upside and shared downside” could produce healthier incentives than one dominated by ever-growing sovereign debt."

I said: Thanks! I might soon be back on this.

It replied: You’re welcome. It is an interesting line of thought because it touches the core issue of development finance: whether institutions are rewarded mainly for disbursing funds, or for helping create durable productive capacity and resilience. I’ll be glad to continue whenever you return to it.

I asked Grok: Briefly please. Around 200 words.

“If the multilateral development banks’ help came in form of investments to be paid back through dividends at a somewhat higher rate than what they would have charged on their loans, could that align better the incentives for both sides?”

Grok replied:

"Yes, it could align incentives significantly better.

Traditional MDB loans create misaligned incentives: banks get repaid regardless of outcomes (often with IMF/Paris Club bailouts), while borrowers bear full downside risk and face rigid repayment schedules that can crowd out growth. Equity-style investments—where MDBs provide capital in return for dividends at, say, 2–3 percentage points above their usual lending rates—flip this dynamic.

Both sides now have skin in the game. MDBs succeed only if the funded projects or reforms actually generate sustainable growth and cash flows; they are incentivized to pick better projects, supply smarter technical assistance, and monitor performance more rigorously. Recipients avoid the debt overhang that distorts policy (austerity, tax hikes, or default cycles). Dividends are paid only when there is profit, giving countries breathing room during bad times and sharing upside during good ones.

This structure resembles how successful development finance arms like IFC already operate in the private sector, or how venture capital aligns founder-investor interests. Politically it is harder—governments dislike ceding any ownership stake or dividend obligations—but the economic logic is sound: it turns MDBs from creditors into genuine development partners whose returns depend on the country’s success, not just its solvency.

I said: Thanks! I might soon be back on this.

It replied: You're welcome! Glad the idea resonated. I'll be right here whenever you're ready to pick it up again—happy to brainstorm more details, run some numbers, or explore counterarguments. Just say the word. 

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

Note: An example of what I mean. 

AI - ChatGPT - Grok: With Basel Committee’s risk weighted bank capital/equity requirements, would the “developed world” have developed?

 United Nations - Human Rights: 1986 -Declaration on the Right to Development

Naciones Unidas - Derechos Humanos: 1986 - Declaración sobre el derecho al desarrollo

2003, during a Risk Management Workshop for Regulators at the World Bank, as an Executive Director, I made the following statement:

"The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel [Committee]."

In a letter published 2004 in the Financial Times: “We wonder how many Basel propositions it will take before they start realizing the damage, they are doing by favoring so much bank lending to the public sector.”

Are bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007

Fast forward to 2025, below is the artificial intelligence’s opinion on that:

I asked ChatGPT: In 200 words or less please opine on:

"If instead of 1988, one year before the fall of the Berlin Wall, Basel Committee risk weighted bank capital/equity requirements had been imposed 1788, one year before the French Revolution, would what’s known as the developed world, have developed?"

ChatGPT answered:

"Had Basel-style risk-weighted bank capital rules been imposed in 1788, the “developed world” as we know it is unlikely to have developed.

Those rules systematically privilege lending to the sovereign and to politically favored, asset-backed borrowers, while penalizing credit to entrepreneurs, merchants, and small producers—the very agents who drove the Industrial Revolution. In 18th-century Europe, development depended on risk-taking: financing canals, mills, shipping ventures, workshops, and technological experimentation, most of which lacked collateral and state guarantees. Basel logic would have labeled such activity “high risk” and forced banks either to ration credit or charge prohibitive terms.

By contrast, cheap capital to governments would have reinforced mercantilist states, war finance, and court consumption, not productivity growth. Innovation would have migrated even more toward informal finance or remained unrealized altogether."

I said: Thanks!

It replied: You’re very welcome. Glad it was useful.

I asked Grok: In 200 words or less please opine on:

"If instead of 1988, one year before the fall of the Berlin Wall, Basel Committee risk weighted bank capital/equity requirements had been imposed 1788, one year before the French Revolution, would what’s known as the developed world, have developed?"

Grok answered:

"No, the developed world likely wouldn't have developed as rapidly or extensively. In 1788, Europe and emerging economies relied on nascent banking systems to fuel the Industrial Revolution, colonial expansion, and infrastructure booms. Banks like the Bank of England (1694) operated with minimal capital constraints, enabling aggressive lending for risky ventures—canals, factories, trade—that drove growth.

Imposing Basel I-style risk-weighted capital requirements (e.g., 8% equity against assets) would have forced banks to hold more reserves against "risky" loans, curbing credit availability. Historical evidence from post-1988 shows such rules reduced lending to SMEs and high-risk sectors, slowing innovation. In the 19th century, unchecked banking fueled booms (and busts), but overall propelled GDP growth; strict rules might have stifled railways, steam power, and urbanization.

While preventing some crises (e.g., fewer panics like 1797), the trade-off would be stagnation—think slower tech adoption, delayed imperialism's wealth transfer. Development required risk; Basel's caution in 1788 could've left the "developed world" agrarian and fragmented."

I said: Thanks.

It replied: You're welcome! Glad you enjoyed the take.

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.

 

Agosto 2002 – en TalCual: "Guacara no es Basilea”

AI - ChatGPT - Grok: With Basel Committee’s risk weighted bank capital/equity requirements, would the “developed world” have developed?

 United Nations - Human Rights: 1986 -Declaration on the Right to Development

Naciones Unidas - Derechos Humanos: 1986 - Declaración sobre el derecho al desarrollo

2003, during a Risk Management Workshop for Regulators at the World Bank, as an Executive Director, I made the following statement:

"The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel [Committee]."

In a letter published 2004 in the Financial Times: “We wonder how many Basel propositions it will take before they start realizing the damage, they are doing by favoring so much bank lending to the public sector.”

Are bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007

Fast forward to 2025, below is the artificial intelligence’s opinion on that:

I asked ChatGPT: In 200 words or less please opine on:

"If instead of 1988, one year before the fall of the Berlin Wall, Basel Committee risk weighted bank capital/equity requirements had been imposed 1788, one year before the French Revolution, would what’s known as the developed world, have developed?"

ChatGPT answered:

"Had Basel-style risk-weighted bank capital rules been imposed in 1788, the “developed world” as we know it is unlikely to have developed.

Those rules systematically privilege lending to the sovereign and to politically favored, asset-backed borrowers, while penalizing credit to entrepreneurs, merchants, and small producers—the very agents who drove the Industrial Revolution. In 18th-century Europe, development depended on risk-taking: financing canals, mills, shipping ventures, workshops, and technological experimentation, most of which lacked collateral and state guarantees. Basel logic would have labeled such activity “high risk” and forced banks either to ration credit or charge prohibitive terms.

By contrast, cheap capital to governments would have reinforced mercantilist states, war finance, and court consumption, not productivity growth. Innovation would have migrated even more toward informal finance or remained unrealized altogether."

I said: Thanks!

It replied: You’re very welcome. Glad it was useful.

I asked Grok: In 200 words or less please opine on:

"If instead of 1988, one year before the fall of the Berlin Wall, Basel Committee risk weighted bank capital/equity requirements had been imposed 1788, one year before the French Revolution, would what’s known as the developed world, have developed?"

Grok answered:

"No, the developed world likely wouldn't have developed as rapidly or extensively. In 1788, Europe and emerging economies relied on nascent banking systems to fuel the Industrial Revolution, colonial expansion, and infrastructure booms. Banks like the Bank of England (1694) operated with minimal capital constraints, enabling aggressive lending for risky ventures—canals, factories, trade—that drove growth.

Imposing Basel I-style risk-weighted capital requirements (e.g., 8% equity against assets) would have forced banks to hold more reserves against "risky" loans, curbing credit availability. Historical evidence from post-1988 shows such rules reduced lending to SMEs and high-risk sectors, slowing innovation. In the 19th century, unchecked banking fueled booms (and busts), but overall propelled GDP growth; strict rules might have stifled railways, steam power, and urbanization.

While preventing some crises (e.g., fewer panics like 1797), the trade-off would be stagnation—think slower tech adoption, delayed imperialism's wealth transfer. Development required risk; Basel's caution in 1788 could've left the "developed world" agrarian and fragmented."

I said: Thanks.

It replied: You're welcome! Glad you enjoyed the take.

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.

 

Agosto 2002 – en TalCual: "Guacara no es Basilea”

#AI ChatGPT: Can regulatory risk aversion affect development?

I asked ChatGPT:

"There’s risk aversion imbedded in risk weighted bank capital/equity requirements based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived or decreed as safe. Can that hinder the development of e.g., developing nations?"

ChatGPT answered:

"Yes, the risk aversion embedded in risk-weighted bank capital/equity requirements can potentially hinder the development of developing nations. This is primarily because risk-weighted capital requirements tend to assign higher risk weights to assets or investments in developing nations compared to those in developed nations.

Risk-weighted capital requirements are designed to ensure that banks hold sufficient capital to absorb potential losses arising from their assets. However, the perception of higher risk associated with developing nations often leads to higher risk weights being assigned to loans and investments in these countries. As a result, banks may be required to hold more capital against their exposures to developing nations, making it more expensive for them to finance projects or provide loans in those countries.

This higher cost of capital can deter banks from extending credit to businesses and individuals in developing nations, limiting access to financing and impeding economic growth and development. It can also lead to a reduced flow of foreign direct investment (FDI) into these countries, as investors may view the higher capital requirements as an additional barrier to entry.

Furthermore, the perception of higher risk can create a negative cycle where the lack of access to affordable financing hampers investment, innovation, and entrepreneurship in developing nations. This, in turn, may slow down economic growth and limit opportunities for job creation and poverty reduction.

To address this issue, policymakers and international organizations have recognized the need to strike a balance between prudential regulation and the promotion of economic development. Efforts have been made to refine risk assessment methodologies and provide more nuanced risk weightings that reflect the specific characteristics of developing nations. Additionally, initiatives such as the World Bank's International Development Association (IDA) and various regional development banks aim to provide concessional financing and technical assistance to support development projects in these countries.

Overall, while risk-weighted capital requirements play an important role in maintaining the stability of the banking system, it is crucial to ensure that they do not inadvertently hinder the development of developing nations. Striking the right balance between risk management and supporting economic growth is a complex challenge that requires ongoing attention and cooperation between regulators, policymakers, and international organizations."

Comment: How long can the experts on development ignore this and still be considered experts?

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

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

PS. Here a 2003 warning about Basel bank regulations and development

UN, World Bank, IMF, and NGO’s: Give the SDGs a fair chance. Kick out Basel Committee's bank regulations

The Sustainable Development Goals seem all very laudable, but given that bank credit is one of the most important financial resources, in order for these to stand a fair chance of being met, one would have to kick out all current bank regulators… or at least their regulatory pillar, the credit risk weighted capital requirements for banks. 

Hear me out!

Those capital requirements, where capital mostly signifies bank equity, decree more credit risk more capital – less credit risk less capital. That might sound logical, but it is not!

That means that banks are allowed to leverage more their equity (and the various sort of support they receive from taxpayers) when lending to what is perceive as safe than when lending to what is perceived as risky; which means banks can earn higher risk-adjusted returns on equity when lending to The Safe than when lending to The Risky; and which makes it impossible for banks to treat all borrowers fairly.

Specifically those bank regulations, which only single purpose is to avoid credit risk, something which has nothing to do with financing sustainability, poverty reduction or job creation, would directly impede the following SDG-Targets: 

1.4: ensure that all men and women, in particular the poor and the vulnerable, have equal rights to economic resources

1.5.a: Ensure significant mobilization of resources from a variety of sources…

2.3: equal access to… financial services… 

8.3: Promote development-oriented policies that support productive activities, decent job creation, entrepreneurship, creativity and innovation, and encourage the formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services.

8.10: Strengthen the capacity of domestic financial institutions to encourage and expand access to banking, insurance and financial services for all…

9.3: Increase the access of small-scale industrial and other enterprises, in particular in developing countries, to financial services, including affordable credit, and their integration into value chains and markets 

10.3: Ensure equal opportunity and reduce inequalities of outcome, including by eliminating discriminatory laws, policies and practices and promoting appropriate legislation, policies and action in this regard 

15.10.a: Mobilize and significantly increase financial resources from all sources to conserve and sustainably use biodiversity and ecosystems 

15.10.b: Mobilize significant resources from all sources and at all levels to finance sustainable forest management and provide adequate incentives to developing countries to advance such management, including for conservation and reforestation 

17.1: Strengthen domestic resource mobilization 

17.3: Mobilize additional financial resources for developing countries from multiple sources 

You might say that to ignore such capital requirements would put the banks at risks. Forget it! Major bank crisis do never result from excessive exposure to what is perceived as risky, these always, no exceptions, result from excessive exposures to what was erroneously perceived as safe.

Motorcycles are much riskier than cars, but much more people die when going in cars than when riding motorcycles.

If we do not want banks to take risks in order to create jobs, in order to reduce poverty and in order to help the sustainability of earth… then what the hell do we want banks for… safe mattresses would do. 

I am not much for distorting credit allocation in any way, I believe it is way too arrogant for us to pretend we know how, but, if we have to do it, I would much prefer allowing banks to hold a bit less capital when lending to something related to the SDGs, so that they make a bit more return on equity when lending to the SDGs, so that they lend a bit more to the SDGs.

Let me finalize here by quoting from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is.”

The IMF keeps on ignoring one of the prime causes for manmade inequality... the risk adverse bank regulations

In June 2015 the IMF made public a paper titled “Causes and Consequences of Income Inequality: A Global Perspective”. It was prepared by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta (with contributions from Preya Sharma and Veronique Salins) and authorized for distribution by Siddharh Tiwari.

Once again, one of the fundamental manmade and artificial drivers of inequality is not mentioned. I refer to the credit-risk-weighted capital requirements for banks which allow banks to earn much higher risk-adjusted returns on equity, when lending to what is perceived or made to be perceived as “safe”, than to what is perceived as “risky”, like to SMEs and entrepreneurs. 

That regulation kills opportunities and impedes banks from financing the future, dedicating them mostly to refinancing the past. Of course that promotes inequality.

Also there is no mention about the bailouts directed to safeguard the value of existing assets, which also promotes inequality, as it does not do remotely as much for those who have no assets. 

In the final remarks the paper states: “The promotion of credit without sufficient regard for financial stability, however, can result in crises, as evidenced by the subprime mortgage crisis in the United States, with disproportionately adverse effects on the poor and the middle class. Moreover, it illustrates the broader point that deep social issues cannot be resolved purely with an infusion of credit. Policies thus need to strike a balance between fostering prudence stability, and inclusion, while encouraging innovation and creativity.” 

In my opinion that is a serious misstatement of financial history. Mortgages to the subprime sector never represented major problems, until Basel II regulations in June 2004 allowed banks to hold securities against only 1.6 percent in capital, meaning allowed leverage of more than 60 to 1, as long as they were rated AAA to AA. That, as should have been expected, set of a frantic demand for, and an ensuing production of, AAA-AA rated securities. In January 2003 in FT I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

I hold that credit risk weighted capital requirements for banks seriously distort the allocation of bank credit to the real economy. The World Bank in its Global Development Finance 2003, “Striving for Stability in Development Finance” already hinted at the distortion, since under the topic of Basel II it stated:  

“risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”

Unfortunately it seems this type of criticism was off-limit as it has since then been silenced.

World Bank, to help raise finance for MDGs and SDGs, suggest MDG and SDG-weighted equity requirements for banks.

Right now the banks finance more than ever what is perceived as safe, because that allows them to hold less equity than when financing what is perceived as “risky”, and so there is where they earn their highest risk adjusted returns on equity.

If the World Bank wonders how to get sufficient finance to meet the MDGs and the SDGs… then think of bank equity requirements not based on credit risk weights but on Millennium Development Goals DG and Sustainable Development Goal Weights. 

That way banks would earn higher risk adjusted returns on equity when doing good.

That would help to put some purpose back into banks… because credit risk weighted equity requirements certainly do not.

The Development Committee Communiqué, April 2015. Another missed opportunity to make a real difference

The Development Committee (DC) is a ministerial-level forum of the World Bank Group and the International Monetary Fund for intergovernmental consensus-building on development issues. Its mandate is to advise the Boards of Governors of the Bank and the Fund on critical development issues and on the financial resources required to promote economic development in developing countries.

In its Communiqué after the 2015 Spring Meetings in Washington on April 18, 2015 it included the following:

“We call on the World Bank Group (WBG) and the International Monetary Fund (IMF) to support countries’ efforts to spur inclusive growth and job creation and build resilience to adverse shocks, in order to reduce poverty, and enhance shared prosperity in a sustainable manner, and protect hard-won gains in these areas.”

And I have to ask: Why on earth can they not ask the Basel Committee for Banking Supervision (BCBS), the committee that designs bank regulations to be applied for banks around the globe, the same thing?

As is, the pillar of BCBS’s bank regulations is risk-weighted capital requirements for banks, or more precisely portfolio invariant credit-risk-weighted equity requirement for banks. And this has nothing to do with “inclusive growth and job creation and build resilience to adverse shocks”.

On the contrary, since it translates into less-risk-less-equity, and since all major bank crises in history have never resulted from excessive exposures to something perceived as risky but always from excessive exposures to something erroneously perceived as safe, it only set up the banking system to even larger adverse shocks.

Also, since it of course also translates into more-risk-more-equity it means that banks will lend less and relatively more expensive to the “risky”, like SMEs, something which kills opportunities and thereby foments more inequalities. 

In short the Development Committee should have taken the opportunity to ask BCBS to substitute for the credit-risk-weights with something more purposeful for the society. For example with the potential of planet earth sustainability, job generation and poverty reduction weights.

And indeed, since risk-taking is the oxygen of any development; and it is the future generations who most need banks to take astute risks in order for them to have a better future, the World Bank should be instructed to act as the Ombudsman for the best interests of our children and grandchildren.

The World Bank should act as an Ombudsman for our children and grandchildren

The Basel Committee for Banking Supervision (BCBS) is in charge of developing bank regulations that are applied by more and more countries around the world. That has increased the coherence and reduced somewhat the regulatory competition between countries. Unfortunately, it has also introduced a serious systemic mistake. 

The pillar of the BCBS’s current bank regulations, is the risk weighted capital requirements for banks; something which for more preciseness, should be termed the Portfolio Invariant Credit-Risk-Weighted Bank Equity Requirements. In essence it indicates: more-credit-risk-more-equity / less-credit-risk-less-equity. 

Though intuitively it sounds very reasonable, it contains two fundamental flaws.

First, the risk-weights used are based on the default possibilities of the assets of a bank, and not on a real analysis of what has caused the major bank crises in the past. In this respect it should be noted that the bank assets more likely to cause a major crisis, are not those perceived as risky, but those that are erroneously perceived as safe.

Second, much worse, allowing banks to leverage their equity, and the explicit and implicit support these receive from taxpayers, differently, depending on credit risks already cleared for with interest rates and size of exposures, seriously distorts the allocation of bank credit to the real economy. In essence it causes the bank system to lend too much and at too low rates to what is perceived as safe, like for instance to sovereigns and what I have termed as the AAArisktocracy; and too little, at relatively too high interest rates, to what is perceived as risky, like for instance to SMEs and entrepreneurs.

The origin of this mistake can primarily be traced to that regulators never really defined the purpose of our banks, beyond that of each one having to be safe. With that the regulators completely ignored that banks represent one of the most important agents through which the society distributes its savings, and the risk-taking that the economy needs in order to move forward, so as not to stall and fall.

Any regulatory interference and distortion of how bank credit is allocated, is very dangerous, and so, if it is to be considered and allowed, one needs to make certain that, at the very least, it is in pursuit of some extremely worthy purpose.

In this respect it could be illustrative, instead of credit-risk-weights, to think about the potential-of-job-generation weights, or environmental-sustainability-weights. That would allow the banks to earn their highest risk-adjusted returns on equity, financing what could most matter to us.

The World Bank, as the world’s premier development bank, must know that risk-taking is the oxygen of any development. It therefore has an enormously important role in supervising bank regulations from the point of view of how banks: promote development, allow for fair and inclusive access to finance, advance poverty reduction, generate jobs and help to bring on environmental sustainability.

The challenges loom large. Current credit risk based equity requirements, by making it harder than need be for those perceived as “risky” to access bank credit, kills opportunities and thereby promotes inequality. And, with its bias against credit-risk, it guarantees that banks will not finance sufficiently the “riskier” future, but mostly keep to refinancing a “safer” past.

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

The credit-risk-aversion present in current regulations could seem adequate for someone retired with a remaining short life expectancy. It is highly inadequate though, in fact dangerous, when set in the context of the needs of future generations. And in this respect I urge the World Bank to cast itself much more in the role of being the Ombudsman for our children and grandchildren.

And let us, somewhat older, never forget that much of what we can enjoy today, is the direct result of the willingness of the generations that preceded us to save and to take risks. We have the same duty… God make us daring!

@PerKurowski

PS. Here a statement closely related to this issue that I delivered as an Executive Director of the World Bank March 10, 2003

Reserve Bank of India: This is not so smart of you. In fact it is quite dumb.

The Reserve Bank of India has decided that Basel III standards for capital (equity) and liquidity shall apply for lenders operating in the country.

That means that in India they will keep applying the regulatory pillar of more-perceived-credit-risk-more-equity and less-perceived-credit-risk-less equity.

Which means lenders in India will be able to leverage their equity, and the support they receive from taxpayers, much more with net margins collected on loans to those perceived as “safe” than on loans to those perceived as “risky”.

Which means that lenders in India will make much higher risk adjusted returns on equity when lending to those perceived as “safe” than on loans to those perceived as “risky”.

Which means that lenders in India are doomed to lend too much at too low rates to those perceived as “absolutely safe” and too little at too high rates to those perceived as “risky”, like the SMEs, entrepreneurs and start-ups. 

That, for a developing country, does not sound so smart, in fact it is quite dumb.

And all this happens probably only so that some Indian regulators can show off in front of their colleagues in the developed countries.

But, even for developed countries that Basel pillar is dumb. It is like if a young professional setting up his retirement account he tells his investment manager: “I will pay you much higher commission on earned returns from investments in what is thought safe than what I will pay for the case of investments in what seems risky”. That will lead to excessive risk aversion and probably cause him a very poor retirement income.

Have India and other developing countries completely forgotten that risk-taking is the prime oxygen of any development?

Developing countries have clearly forgotten what made them develop… and have now, with these regulations that so odiously discriminate against the fair access to bank credit of “the risky” have call it quits, and begun un-developing.

And all for nothing since never ever do major bank crises result from excessive exposure to what is perceived as risky, these do always, no exceptions, result from excessive exposures to something perceived as absolutely safe, but that ex post turned out very risky.

PS. From some things I have heard about India, and from some experiences I have had in my country, Venezuela, it would seem that equity requirements based on closeness-to-borrower ratings could make some sense. The closer the bank, and its board are to the borrower, for instance they could be siblings, the higher the equity requirement.

It behooves us all to denounce the Basel Committee's dumb and odiously discriminating bank regulatory pillar.

Currently the pillar of regulations, peddled all over the world under the trademark of Basel Committee, is equity requirements for banks based on perceived credit risk… more risk more capital… less risk less capital.

That is extremely dangerous for all, especially for developing countries. 2 reasons:

By allowing banks to leverage more their equity when lending to the safe than when lending to the risky, banks will obtain higher risk adjusted returns on equity when lending to the safe than when lending to the risky, which results in banks lending too much at too low rates to the safe and too little at relative too high rates to the risky. And who are the "risky"? All those SMEs, entrepreneurs and start-ups everyone needs and wants to have fair access to bank credit, for the economy to grow and not stall and fall.

And all which that pillar guarantees is that whenever a major bank crisis happens, those which never result from excessive exposures to the risky, but always because of excessive exposures to the “safe”, the banks will stand there naked, with little or no equity to cover themselves up with.

The regulators should have asked: “What are the risks bankers will either not perceive the risks of bank assets, or be able to manage the risks correctly?”... and that is clearly something quite different from what the perceived risks of bank assets are.

It behooves us all to denounce that dumb and odiously discriminating regulatory pillar.

I hear you: “Could expert regulators really be that stupid?” Yes, that is perfectly possible, especially when they regulate in a mutual admiration club isolated from the real economy.

For instance, when was the last time you saw a small business owner or an aspiring not yet successful entrepreneur in need or bank credit in Davos, or being heard out by the Basel Committee or G20's Financial Stability Board? 

 

I prefer one and the same equity requirements against all bank assets, because for me it is always dangerous to distort the allocation of bank credit to the real economy.

But, if regulators absolutely must distort, in order to show us they are earning their salaries, then let us please ask them to substitute with potential of job-creation-ratings, sustainability-ratings, or any other rating of what could be the purpose of a bank, for those useless credit ratings which are already considered by bankers when giving the loans, and should therefore not be considered again in the equity.

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

God make us daring!

World Bank, the world urgently needs another chapter of your “World Development Report 2015: Mind, Society, and Behavior”

The World Bank argues in their “World Development Report 2015: Mind, Society, and Behavior”, that a more realistic account of decision-making and behavior will make development policy more effective. 

Indeed, and what a fabulous opportunity to ask the World Bank, in light of that report, to evaluate how expert regulators like those in the Basel Committee for Banking Supervision could have come up with something as irrational as their portfolio invariant perceived credit risk weighted capital (equity) requirements for banks… more risk more capital – less risk less capital.

Let me summarize its two main irrationalities.

Fact: All major bank crises have resulted from excessive exposures to assets that while they were being incorporated to the balance sheets of banks were considered safe, but that ex post turned out to be risky; and no bank crisis has resulted from excessive exposures to assets that while they were being incorporated to the balance sheets of the banks were considered risky, even if in fact they really turned out to be risky.

And yet: “more risk-more capital - less risk-less capital”? Should it not be the opposite?

Fact: Through interest rates, size of exposures and other terms, banks clear for perceived credit risk. To then make banks clear again for basically the same perceived risk in their capital (equity) condemns the banks to overdose on perceived credit risks. Worse yet, by allowing much lower capital against assets perceived as safe, the banks will earn much higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. 

And such distortion makes it completely impossible for banks to perform correctly what is its most important social function, namely to allocate bank credit efficiently to the real economy.

So how on earth could bank regulators have committed these two fundamental mistakes? And how on earth is it that so many years after the crisis exploded because of excessive bank exposures to what had very low capital requirements the causality has not been acknowledged? And how on earth is it that when clearly “risky” small businesses and entrepreneurs are squeezed out from access to bank credit because they cause the banks to need more capital this causality, again, is not acknowledged. These are questions the World Bank should help to get answers for.

In March 2003, as an Executive Director of the World Bank I stated: “Basel is getting to be a big rule book,” and, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.”

And in April 2003, in a written statement delivered at the WB Board I wrote: "Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basle’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

And I still hold all that. And so please, dear World Bank, as the world’s premier development bank don’t shy away from your responsibilities. Risk-taking is the oxygen of development and so these regulations are anathema to development. And by negating the risky a fair access to the opportunities of bank credit, these regulations are also impeding the world from being a more equitable world. 

As a starting point and having briefly read in this WDR-2015 about “automatic” and “deliberative” decisions system (and of course Daniel Kahneman) let me advance that those responsible for the risk weighting, automatically concluded that “safe is safe and risky is risky” and took it from there, without deliberating sufficiently on that in bank regulations, "safe could be risky and risky could be safe"; in other words without any consideration to differences in ex ante and ex post perceptions.

And as to the regulatory distortions in credit allocation these regulations could cause, and that were so blatantly and irresponsibly ignored, let me just point that nowhere in all the soon thousands of pages of Basel Committee and Financial Stability Board regulations, can we find a statement that indicates the “purpose of our banks”.

What do I specifically want? I want all those involved in writing the “WDR-2015” to tackle a rewriting of Chapter 10: “Improving the work of development professionals”, in terms of: “Improving the work of bank regulation professionals”. 

Since bank regulators can have a large systemic dangerous, or beneficial, influence on how our future is painted, the world would benefit enormously from that.

PS. I am not only referring to the developing world. Currently Europe is stalling and falling, as a direct consequence of these risk-adverse bank regulations, and so it is high time for someone like WB to remind them of what helped them to develop in the first place. Let us be clear, with bank regulations like Basel I, Basel II and now Basel III, Europe (or the rest of the Western world) would not have become what it is.

Is this good for developing countries? (or even for developed ones?)

Many developing countries, because their government bureaucrats do not want to seem less sophisticated than their counterparts in the developing countries, have adopted the Basel Committee for Banking Supervision as expressed in Basel II and soon Basel III.

The pillar of those Basel regulations is something called credit-risk weighted capital (equity) requirements for banks, more risk more bank equity – less risk less bank equity.

And that allows banks to earn much higher risk-adjusted returns on equity on what is perceived ex ante as “absolutely safe” than on what is perceived as “risky”.

Questions: Do you think developing countries can develop by giving the banks incentives to populate safe-havens, possibly causing a dangerous overcrowding of these, and keeping away from exploring the risky bays? Is not risk-taking the oxygen of development? Do you think that developed countries can stop taking risks and not stall and fall?

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

Dear development organization

Current bank regulations, which are being imposed globally, have as their principal pillar that of capital requirements based on perceived risk; the more the risk the higher the capital, the lower the risk the lower the capital. That, although at first it sounds logical is something extremely dangerous for the economies, because the perceived risks are already cleared for, by banks and markets, through interest rates, amounts of exposures and other contractual terms. 

The result of those regulations which double-count perceived risks, is that banks are able to earn much higher risk adjusted returns on equity when investing in or lending to “The Infallible”, than when investing in or lending to “The Risky”, like small businesses, entrepreneurs and most infrastructure and development projects. 

That of course makes it much more difficult for “The Risky” to access bank credit, or forcing them to accept much higher interest rates, much smaller loans and much harsher terms than would have been the case without these regulations. 

In this respect I wonder if your organization, so much involved in the development efforts of the world, and that must be aware of the fact that risk-taking is the oxygen of any development, has any interest in supporting my efforts to eliminate these regulatory subsidies to “The Infallible”, and the consequential taxes on The Risky”. 

Our banks are currently drowning in dangerous excessive exposures to what is officially considered as “The Infallible”, while credit needs for so many productive projects of “The Risky” are completely ignored.

Yours sincerely 

Per Kurowski
A former Executive Director at the World Bank (2002-2004)
perkurowski@mail.com
http://subprimeregulations.blogspot.com/

Development economists, you have now been shamed

Now most development economists have been shamed by none other than Vikram Pandit, the chief executive of the Citigroup and who, in the Financial Times of October 26, is reported as saying “Under Basel, the ‘sweet spot’ business model for banks in the developed world will be to take retail deposits from mom and pop – small but stable customers – and lend only to big business and the wealthy. I do not believe this is the banking system we want”

Of course this is not the arbitrary regulatory discrimination we need, and I have been arguing against it since 1997 with for example a document I presented at the UN in October 2007 titled “Are the Basel bank regulations good for development?”. Unfortunately much of the development debate of developing countries has been hijacked by baby-boomer development economists from developed countries and who cannot get it in their head that development requires a lot of risk-taking… and that therefore concentrating too much on avoiding bank failures will hinder the growth and the development of the economy.

As an example it suffices to read the Recommendations by the Commission of Experts of the President of the General Assembly on reforms of the international monetary and financial system chaired by Joseph Stiglitz. Nowhere in it do we find a word about the utterly misguided and odiously discriminatory capital requirements for banks imposed by the Basel Committee and which signify that a bank needs to have 5 TIMES more capital when lending to small businesses and entrepreneurs (100%-risk-weight) than when lending to triple-A rated borrowers (20%-risk-weight); and this even though the first are already paying much higher interest which goes to bank capital; and this even though no financial crisis has ever resulted from excessive lending to those perceived as “risky” as they have all resulted from excessive lending to those ex-ante perceived as not risky.

The Commission of Experts speak of increasing risk-premia but fail to notice that one of the reasons for that is the arbitrary regulatory risk-adverseness. It also speaks out against under-regulated and dysfunctional markets that fail to allocate capital to high productivity uses, without noticing that perhaps the major cause of markets being dysfunctional is often bad regulations, such as those issued by the Basel Committee.

Perhaps it is high-time economists from developing countries start to develop their own development paradigms; some of which might even help developed countries to keep from submerging.

And meanwhile, all you traditional development economists, put on your cones of shame.

A final question should Vikram Pandit now move on to the World Bank?