ChatGPT 4.0 on "Synthetic Contingent Liability" Clawback Regulation

A First Attempt

Dec 04, 2024

In my last blogpost, I wrote about how I got ChatGPT 4.0 to write regulatory code for five academic proposals to simplify bank capital regulation in the style of the Code of Federal Regulations (CFR). In this blogpost, I provide the output from a similar exercise to get ChatGPT 4.0 to write the regulatory code in the style of the CFR to implement “Synthetic Contingent Liability.” The idea for this blogpost derives from one I wrote earlier this year about a simple way to design executive clawbacks to implement what Congress called for in Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) of 2010.

To recap, the idea calls for recreating contingent liability, which most state and national bank shareholders were subjected to prior to the creation of the Federal Deposit Insurance Corporation, synthetically. By synthetically, I mean the proposal recreates the payoffs of contingent liability, without having to change the actual liability of the underlying shares - that way you can avoid debates about whether retail investors would understand contingent liability shares. Moreover, unlike contingent liability in the past, this idea can also apply to options compensation - though it might reduce executive options compensation.

The merits of contingent liability arise from the fact that prior to the creation of the Federal Reserve’s Discount Window, most bank owner-shareholders closed their weak bank early so that they could avoid paying the contingent liability penalty. They did what Silvergate did in March 2023 and avoided failure by voluntarily liquidating. As such, contingent liability limited the fiscal costs of banking crises.

Before displaying the output, “Synthetic Unlimited Liability” would be the most onerous form of this idea as it makes executives of failed banks pay a fraction of 100% of the ex post resolution or bailout costs. The less onerous “Synthetic Contingent Liability” makes executives of failed banks pay a fraction of less than 100% of the ex post resolution or bailout costs. Note, under this framework the current de facto fraction of the resolution or bailout costs that executives are on the hook for equals 0%; I leave it to regulators to specify the appropriate penalty to set above 0%. Also, for executives who might want to track how much of their shares compensation they might lose under Synthetic Contingent Liability if their bank fails or gets bailed out, they could estimate such losses ex ante using the debt guarantee estimate methodology and results I discussed earlier this year - or they might use some other variant, instead. Lastly, rather than getting ChatGPT 4.0 to make final tweaks to the language, I made some minor revisions. For instance: 1) I made the references to put spreads plural as ChatGPT did not, 2) ChatGPT used a 50% cap as an example, but I added 25% and 100% as other examples, and 3) in Subpart B, §X.4, (b) Purpose of Capped Downside I did have to revise the aim to increase liability, as ChatGPT wrote that it limited liability. Otherwise, here’s a first approximation view of what the regulation might look like if this proposal gets used in a final rulemaking:

Title 12 – Banks and Banking

Part X – Clawback Regulation for Bank Executives (Synthetic Contingent Liability)

Subpart A – General Provisions

§X.1 Purpose and Scope
This part establishes requirements for a capped form of Synthetic Contingent Liability (SCL) for bank executives, designed to provide incentives for prudent risk management while capping liability at a defined level. SCL applies to both equity shares and call options compensation and requires executives to assume financial responsibility for a capped portion of costs incurred by the government to resolve or assist their institution.
(a) For failed banks, resolution costs shall be determined by the Federal Deposit Insurance Corporation (FDIC) after the resolution process is complete.
(b) For government assistance to prevent bank failure, bailout costs shall be determined by the Congressional Budget Office (CBO).
§X.2 Definitions
(a) Synthetic Contingent Liability (SCL): A regulatory mechanism that requires bank executives to assume financial liability for a set percentage of resolution or bailout costs proportional to their share of equity ownership.
(b) Capped Resolution Cost Liability: The executive’s liability is limited to a fixed percentage (e.g., 25%, 50%, or 100%) of the total resolution or bailout assistance costs.
(c) Put Spreads for Options Compensation: A synthetic position where executives compensated with call options on bank shares sell put options at the call option’s strike price and purchase put options with a strike price set at x% lower than the strike of the puts sold, capping the downside risk.

Subpart B – Liability Calculation and Implementation

§X.3 Executive Clawback for Equity Compensation
(a) Capped Equity-Based Clawback Calculation
Executives holding equity shares in the bank are liable for a capped portion of total resolution or bailout costs.
(1) For failed banks, the total resolution cost shall be determined by the FDIC after the resolution process is complete.
(2) For government assistance to prevent bank failure, the total bailout cost shall be determined by the CBO based on the assistance provided.
(3) The executive’s liability is calculated as their fraction of total bank shares multiplied by x% of the total resolution or bailout costs.
(b) Enforcement of Payment
In the event of bank distress, the FDIC or CBO shall notify each liable executive of the capped amount they owe under §X.3(a), to be paid within 90 days of notification.
§X.4 Options-Based Synthetic Contingent Liability Requirement
(a) Requirement for Put Spread Positions
Executives compensated with call options must sell synthetic put spreads by selling puts with the same strike price and expiration as the call options received and purchasing an identical number of puts with a strike price x% lower than the strike price of the calls received and puts sold.
(b) Purpose of Capped Downside
The put spreads increase the executive’s downside exposure on call options compensation, creating a defined cap on liability while maintaining alignment with the bank’s financial performance.
(c) Maintenance of Synthetic Positions
Executives must maintain the put spread positions throughout the duration of the call options held. Non-compliance with this requirement will result in enforcement action as described in Subpart C.

Subpart C – Compliance and Enforcement

§X.5 Reporting and Compliance Certification
(a) Quarterly Reporting: Executives must file quarterly reports disclosing their equity holdings and options positions to ensure compliance with SCL requirements.
(b) Certification of Understanding and Compliance: Executives must certify that they understand their obligations under SCL and agree to fulfill any payments for capped resolution or assistance costs as specified.
§X.6 Enforcement and Penalties
(a) Failure to Comply: Any executive who fails to meet payment obligations under §X.3 or maintain the synthetic contingent liability position under §X.4 will be subject to corrective action and additional penalties as determined by the FDIC or CBO.
(b) Appeal Process: Executives may appeal their calculated liability within 30 days of the FDIC or CBO’s notification, providing supporting documentation as specified by the respective agency.

Word Count Estimate:

Synthetic Contingent Liability Code: Approximately 1,500–1,700 words.