Updated: Jan 24
This is part 2 of a 2 part series.
An excerpt from Part 1:
I have often been curious about 1) why financial institutions have a hard time minding their bezzle? and 2) why regulators have such a hard time regulating the bezzle?
You may be wondering, “What the heck is a bezzle?!” Please stay with me.
In considering the great financial crisis starting in 2007, Ben Bernanke, then the Chairman of the Fed, said:
“...the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”
I suspect for many, this is not a blazing flash of insight. More of a confirmation of something most suspected. The question is, why? Why were regulators unable to prevent the financial crisis if we already knew regulation was necessary? Also, why did financial institutions let the risks driving the bezzle get out of hand? By the way, I know many talented regulators and many talented risk managers, this article considers regulatory and risk management effectiveness as an environmental outcome. If the environmental rules are set up for success, then talented regulators and risk managers will be successful. The environment in 2007 was decidedly not regulator or risk manager friendly.
This article is about the environmental factors that impact regulatory and risk management effectiveness. The primary thesis includes improving regulatory and financial institution risk management consistency, recognizing and managing our human nature impact, decreasing the bezzle inventory, and decreasing the negative impact of inevitable financial cycles. Ultimately, the article begs the question, what can we learn from the past to improve our future? One of my favorite related quotes, sometimes attributed to Mark Twain:
"History Does Not Repeat Itself, But It Rhymes"
That is, if we do not learn from our past, we are doomed to repeat it.
In part 1, we covered -
In part 2, we cover -
Locus of Control
Beyond the regulatory posture, why do business participants cause a change to the bezzle inventory? This is related to the psychology of the "locus of control." When times are good, people focus on themselves and apply an internal locus of control. Our brains are wired to believe that good times are the result of individual achievement. The bezzle grows because of that internal focus. “As long as I’m doing better, I’m not going to be as likely to compare myself to others or otherwise spend my energy on the unfair actions of others.”
When times are bad, people focus on their environment and apply an external locus of control. Our brains are wired to believe that bad times are the result of others. The bezzle shrinks because of that external focus. “It must be others that are causing my pain, so I’m going to seek recompense for unfair action.”
Changes to the locus of control are a failure of invariance and at play in many of our naturally occurring cognitive biases. These changes are framed by the good or bad times circumstances. The truth is, we likely have the same amount of control, and that control is mostly illusory. As such, being vigilant in good times is a good strategy as most others are not. (3) Regulators can help us do that.
Alexander Hamilton is widely considered the primary architect of the U.S. Banking system and our capitalist business environment. In the book Alexander Hamilton, Ron Chernow writes:
“As chief agent of a market economy, he (Hamilton) had to spur acquisitive impulses, accepting self-interest as the mainspring of economic action.”
“Self-interest” relates to Adam Smith and Alexis de Tocqueville’s writing on “enlightened self-interest.” Enlightened self-interest is a philosophy in ethics which states that persons who act to further the interests of others (or the interests of the group or groups to which they belong), ultimately serve their own self-interest. Hamilton's practical and worldly experience may have caused him to doubt the extent to which people are “enlightened” when it comes to their own self-interest.
The beauty of capitalism is its framework to utilize the energy of our human impulses, namely, fear and greed. Then, using guardrails, in the form of laws and regulations, to guide the energy. This was very different from other socio-economic systems that attempt to directly control human impulses through totalitarian command. As such, enlightened self-interest acts as a natural control of an individual's fear and greed. But those controls are not perfect and may be different depending on the economic framing. (As discussed above - Good times or bad times)
The point is, human nature is a given. Our ability to adapt our institutions to our human nature reality is a key element of having an appropriate and consistent level of regulation. All the while, recognizing the driving energy of our capitalistic system is the fear and greed associated with our human nature. Our ability to consistently regulate our business and banking system will cause 1) a decrease in the bezzle, 2) a decrease in the severity of our economic cycles, and 3) a consistent, success-enabled competitive playing field encouraging business success.
(3) a quote from Albert Rutherford's book Systems Thinking - Mental Models
This quote is a good reminder that our external locus may be focused on the closest adjacent external force where there is more control or access. Important to recognize the problems likely are mostly external:
“Avoid operating from a blaming stance, though. Instead of leading a whodunit, encourage questions such as 'How could we have been responsible?' Often, problems are not created by internal forces but external, yet we are still responsible for allowing the external force to influence us. Thus it's useful to ask, 'What did we do to allow these external powers to control us?'”