ChatGPT 4.0 on Simple, Higher Regulatory Capital Requirements
A First Attempt
Over the last ten years, I’ve thought and written a fair amount about simpler, higher regulatory capital requirements as an alternative to complex, risk-weighted capital requirements and their unintended consequences. For a long time, I wondered how different the section on bank capital in the Code of Federal Regulations (CFR) would look if we moved to a simpler regulatory regime. After all, a co-author and I estimated that total word counts that concerned bank capital had risen to at least 20 percent of the total wordcount for the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation after Basel III. That’s even though bank capital typically makes up only a small fraction of one side of a bank’s balance sheet. We also showed that a simpler, higher leverage ratio of 15 percent can be viable. That in mind, I recently began querying ChatGPT 4.0 about how it would write regulatory code for simpler, higher regulatory capital requirements. Unlike existing bank capital regulation, the results are clear and can be read and understood by anyone with a fairly basic understanding of banking.
Before I get to the results, my colleague Markus Bjoerkheim offered two suggestions that helped me arrive at these results. The first was that I should start by uploading regulatory text in pdf format into the ChatGPT prompt. Since I’m focused especially on the capital regime for the largest banks, which were the reason we now have risk-weighted capital, I used the pdf file from Title 12 Part 3 of the CFR, which includes the OCC’s regulation for these banks—ChatGPT estimates the words in the CFR pdf file I uploaded equal 30000-40000 words.
The second was that I could try asking ChatGPT how to ask an LLM the question. I did so using the following query: “What kind of query would you ask an LLM to help you figure out how to get a more effective capital regulation instead of one based on risk-weighting of assets?” In response, ChatGPT offered the following:
"What are the major criticisms of risk-based capital regulation, and what alternative approaches could address issues like undercapitalization during asset declines and unintended consequences of risk-weighting?"
I also offered ChatGPT some additional input from the literature about why I’m concerned about the complexity and unintended consequences of risk-weighted capital, which I list at the end. Along the way, ChatGPT did make some errors in interpreting both the referenced literature as well as the literature that ChatGPT included without prompting, most likely through references. When I caught these errors, I did attempt to correct ChatGPT, if I felt it could have a material effect on the response. The final trick I used was to ask ChatGPT to write the responses in the style of the CFR pdf file I uploaded. Below I list the five simpler, higher regulatory capital alternatives to existing capital regulation.
1. Revised Hypothetical Regulatory Code: 15% Leverage Ratio with Market-Value Accounting
If we adopted a 15 percent equity-to-asset leverage ratio and incorporated market-value accounting, it would only take about 1500-1800 words to describe in the CFR:
Title 12 – Banks and Banking
Part 3 – Capital Adequacy Standards (Leverage Ratio and Market-Value Accounting)
Subpart A – General Provisions
§3.1 Purpose and Scope
This part establishes minimum capital requirements for national banks and federal savings associations, ensuring they issue sufficient non-run-prone funding sources, such as equity and long-term debt, based on total assets measured at market value. This approach eliminates reliance on risk-weighting and emphasizes solvency through leverage and market-value accounting.
Subpart B – Minimum Capital Requirements
§3.2 Leverage Ratio Requirement
(a) A bank must maintain a leverage ratio of no less than 15%.
(b) The leverage ratio is defined as the ratio of equity and long-term funding sources that are not prone to runs (such as equity capital, convertible debt, or other non-deposit liabilities) to total on-balance-sheet assets, measured at current market value.
(c) Banks must calculate their leverage ratio quarterly, based on total assets marked to market. Any significant fluctuations in asset values must be reflected in the leverage ratio calculation to ensure accurate capital adequacy.
Subpart C – Market-Value Accounting
§3.3 Asset Valuation Requirements
(a) All assets on a bank’s balance sheet must be valued at their current market value.
(b) Banks must revalue their assets at least quarterly to reflect real-time market conditions. The current market value should account for changes in asset prices, and banks must maintain documentation to support these valuations.
(c) Any significant decline in market value must be immediately reflected in the bank’s leverage ratio calculations and reported to the appropriate regulatory authorities.
Subpart D – Supervisory Framework
§3.4 Monitoring and Reporting Requirements
(a) Banks must submit quarterly reports to their supervisory authorities, detailing their leverage ratio and providing updated market-value accounting of all assets.
(b) If a bank’s leverage ratio falls below the required 15%, the bank must take immediate corrective action, such as raising additional equity or selling assets to restore the required capital adequacy level.
Word Count Estimate:
Revised Hypothetical Code: Approx. 1,500–1,800 words.
2. Admati and Hellwig (2013) Proposal: Leverage Ratio of 25% or Higher
The next alternative I asked it to write was how to implement Admati and Hellwig’s 20-30 percent leverage ratio. Note, I did not initially prompt ChatGPT about their work, but subsequently asked to provide the regulatory code when it listed their 2013 book in response to one of my queries. Also, the answer’s missing some details in summarizing Admati and Hellwig’s proposal (e.g., highlighting the 25 percent leverage ratio, rather than the 20-30% range). That said, below you can see how ChatGPT would write the CFR text if we implemented ChatGPT’s understanding of their proposal, which would only take about 1000-1200 words to describe:
Title 12 – Banks and Banking
Part 3 – Capital Adequacy Standards (Higher Equity Requirement)
Subpart A – General Provisions
§3.1 Purpose and Scope
This part establishes a minimum capital requirement for national banks and federal savings associations, emphasizing solvency through higher equity capital levels. Banks must issue sufficient equity to provide a robust buffer against losses, independent of asset risk weighting.
Subpart B – Minimum Capital Requirements
§3.2 Leverage Ratio Requirement
(a) A bank must maintain a leverage ratio of no less than 25%.
(b) The leverage ratio is defined as the ratio of equity capital (common stock and retained earnings) to total on-balance-sheet assets, measured at book value.
(c) Banks must ensure that equity capital is maintained above 25% of total assets to provide a sufficient buffer for absorbing losses.
Subpart C – Monitoring and Reporting
§3.3 Reporting Requirements
(a) Banks must submit quarterly reports to supervisory authorities, detailing their leverage ratio and disclosing any changes in equity capital.
(b) Corrective action is required immediately if the leverage ratio falls below 25%, such as raising equity or reducing asset exposure.
Word Count Estimate: Approx. 1,000–1,200 words.
3. Black (1975) Proposal: Dollar-for-Dollar Funding Rule
A third proposal I’ve long wondered about comes from a suggestion that the applied mathematician Fischer Black wrote about in a 1975 article referenced below. Black essentially proposed a dollar-for-dollar rule: for every dollar in deposits (or perhaps short-term funding, generally, today) that a bank has, it must issue a dollar’s worth of equity, and the result would also take about 1000-1200 words to describe:
Title 12 – Banks and Banking
Part 3 – Capital Adequacy Standards (50% Equity Capital Rule)
Subpart A – General Provisions
§3.1 Purpose and Scope
This part establishes a funding rule for national banks and federal savings associations, ensuring that deposits are matched by equity capital, maintaining a 50% equity-to-deposit ratio.
Subpart B – Equity Capital Requirement
§3.2 Dollar-for-Dollar Equity Rule
(a) A bank must issue $1 of equity (common stock or retained earnings) for every $1 of deposits acquired.
(b) Equity must be marked to market and reflect current market value, ensuring that equity capital fluctuates with market conditions to maintain a minimum 50% capital ratio relative to funding.
Subpart C – Monitoring and Reporting
§3.3 Equity Monitoring and Reporting
(a) Banks must continuously monitor the market value of their equity and deposits to ensure compliance with the dollar-for-dollar funding rule.
(b) If equity falls below 50% of total funding, corrective actions must be taken to raise additional equity or reduce deposits.
Word Count Estimate: Approx. 1,000–1,200 words.
4. Merton & Bodie (1993) Proposal: Deposits Backed by Treasuries, Risky Activities Funded by Equity and Long-Term Debt
If you read the Fischer Black biography by Perry Mehrling—Fischer Black and the Revolutionary Idea of Finance—you’ll discover that Black was always open to changing his mind, but he rarely did. I confirmed this with ChatGPT after uploading a pdf of the book that’s available online. That said, bank capital regulation may have been one of those areas where he did change his mind, as Black stated in a 1993 comment that he subscribed to the views that Robert Merton and Zvi Bodie wrote about concerning deposit insurance reform. When I asked ChatGPT if this might have reflected a change in his views, ChatGPT responded by saying:
…it’s unlikely that Black’s agreement with Merton and Bodie in the 1993 article reflects a significant change in his core views, but rather an evolution in how he applied his thinking to practical matters like bank regulation and deposit insurance.
With this background in mind, Merton & Bodie suggest that deposits could be backed by U.S. Treasuries, while risky assets could be funded with equity (common and preferred), and a variety of long-term debt—there’s no explicit capital requirement here, but this proposal relates to the last one that I include by John Cochrane. If you implemented Merton and Bodie’s simpler alternative suggestion instead, the regulatory code would simplify to the following, which would take 1500-1800 words to describe:
Title 12 – Banks and Banking
Part 3 – Capital Adequacy Standards (Deposits, Equity, and Long-Term Debt)
Subpart A – General Provisions
§3.1 Purpose and Scope
This part establishes rules to ensure that deposits are fully backed by safe assets, while risky activities may be funded by a combination of equity and long-term debt.
Subpart B – Deposit Backing
§3.2 Deposit Backing Rule
(a) Banks must back 100% of deposits with U.S. Treasury securities or equivalent risk-free assets.
(b) Deposits must not be used for risk-taking activities. Risky activities must be financed by a combination of equity and long-term debt.
Subpart C – Equity and Debt for Risky Activities
§3.3 Equity and Long-Term Debt Requirement
(a) Banks must fund risky activities through a mix of equity (common stock and retained earnings) and long-term debt (convertible debt or subordinated debt).
(b) Banks must maintain sufficient equity to absorb losses, while long-term debt may be used to complement equity financing.
Subpart D – Monitoring and Reporting
§3.4 Reporting Requirements
(a) Banks must provide quarterly reports detailing the collateralization of deposits with U.S. Treasuries and the financing of risky activities with equity and long-term debt.
(b) Corrective actions must be taken if deposits are found to be uncollateralized or if equity levels are insufficient to absorb risks.
Word Count Estimate: Approx. 1,500–1,800 words.
5. Cochrane’s Proposal: Deposits Backed by U.S. Treasuries, Risky Activities Funded by Equity
John Cochrane in a 2014 paper called “Toward a Run-Free Financial System”, proposes what sounds like a variant of Merton and Bodie’s proposal, in which only U.S. Treasuries again back deposits, but this time, risky bank assets get funded with only common equity. The regulatory code in this case could be as simple as the following, and would take 1200-1500 words to describe:
Title 12 – Banks and Banking
Part 3 – Capital Adequacy Standards (Deposits and Equity Separation)
Subpart A – General Provisions
§3.1 Purpose and Scope
This part establishes rules to ensure that deposits are fully backed by safe assets, such as U.S. Treasuries, while banks’ risk-taking activities are financed entirely by equity.
Subpart B – Deposit Backing
§3.2 Deposit Backing Rule
(a) Banks must back 100% of deposits with U.S. Treasury securities or equivalent risk-free assets.
(b) Banks must not use deposits to fund risky activities. Risky lending and investment activities must be financed through equity capital only.
Subpart C – Equity Financing for Risky Activities
§3.3 Equity Requirement for Risky Activities
(a) Banks must use equity (common stock or retained earnings) to fund all risky activities. No other forms of debt or liabilities are permitted for these activities.
(b) The amount of equity funding must be sufficient to cover potential losses from all risk-taking activities.
Subpart D – Monitoring and Reporting
§3.4 Reporting Requirements
(a) Banks must provide quarterly reports demonstrating that all deposits are backed by U.S. Treasuries and that all risky activities are financed by equity.
(b) Immediate corrective action is required if deposits are found to be backed by anything other than Treasuries or if risky activities are financed by non-equity funding.
Word Count Estimate: Approx. 1,200–1,500 words.
In conclusion, I’ve listed mock CFR regulatory text that ChatGPT 4.0 produced to codify simpler alternatives to current complex bank capital regulation. Some minor errors likely remain, and the answers may change with further prompting and references. Still, these responses seem like a good first approximation if you did want to explore market-oriented regulatory alternatives to what we have now.
References
Barth, James & Miller, Stephen Matteo. (2018b) Benefits and costs of a higher bank “leverage ratio”. Journal of Financial Stability, 38, 37–52.
Black, Fischer. (1975) “Bank Funds Management in an Efficient Market.” Journal of Financial Economics 2, 323–39.
Black, Fischer. (1993). [U.S. Commercial Banking: Trends, Cycles, and Policy]: Comment. NBER Macroeconomics Annual 8, 368–371.
Black, Fischer, Merton Miller, and Richard Posner. (1978) “An Approach to the Regulation of Bank Holding Companies.” Journal of Business 51, 379–411.
Cochrane, John. (2014) “Toward a Run-free Financial System.” In Across the Great Divide, Martin Neil Baily and John B. Taylor (eds.), 197–249. The Hoover Institution Press and Brookings Institution, 2014.
Efing, Matthias. (2020) Reaching for yield in the ABS market: evidence from German bank investments. Review of Finance 24, 929–959.
International Lending Supervision Act of 1983, November 30, 1983. https://fraser.stlouisfed.org/title/1045, accessed on September 26, 2024.
Kapstein, E. (1991) Supervising international banks: origins and implications of the Basle Accord. Essays in international finance, No. 185.
Miller, Stephen Matteo. (2018) “The recourse rule, regulatory arbitrage and the financial crisis.” Journal of Regulatory Economics 54, 195–217.
Miller, Stephen Matteo & Blake Hoarty. (2021) “On regulation and excess reserves: the case of Basel III.” Journal of Financial Research 44, 215–247.
Merton, Robert C., and Zvi Bodie. (1993). Deposit insurance reform: A functional approach. In Carnegie-Rochester Conference Series on public policy 38, Allan Meltzer and Charles Plosser (eds.). Spring.
Miller, Stephen Matteo. (2024) “How Much Would It Cost to Guarantee Debt for All Publicly Traded US Corporations?” Contemporary Economic Policy 42, 604–622.