This is part 1 of a 2 part series.
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 likely, 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, the topics covered are -
Defining the Bezzle, a matter of consistency and counter-cyclicality,
In part 2, we will cover -
First, let's start with The Bezzle.
Based on the earlier comment from Ben Bernanke, you probably already have a good idea of the bezzle's definition. The bezzle was an insightful observation made by economist John Kenneth Galbraith.
“At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle."
(Please see note (1) for the full quote and definition.)
In terms of the bezzle inventory change, think of financial crises and related alignment of interests. When times are good, incentives are aligned across the agents (see “the principal-agent problem” for more information on agency theory). That is, borrowers are borrowing and paying (swapping income for capital assets), lenders are lending, market makers are making markets, and investors are investing (swapping capital assets for income). In good times, the bezzle inventory typically increases. This occurs as business activities in good times are not always risk evaluated as closely as required. In the next section, we will discuss why the bezzle increases in good times.
When the music stops and the economy declines, the participating agents are disrupted and the search for blame starts. The disruptions include borrowers not paying, investors not investing, etc. This blaming, in part, is characterized by the magnitude of the bezzle as created during good times. I do find it interesting that, generally in the good times, the agents are (perhaps unwitting) participants in the bezzle. In bad times, the bezzle inventory typically decreases. Please note, all banks and businesses involve lawyers. Our need for lawyers is a bezzle proof-point!
Also, this relates to the role of the regulator. There is pressure to grow the bezzle inventory during good times. This should be assuaged by a well-defined banking regulatory playing field. Both, defining what is out of bounds, and even more important, enforcing what is out of bounds. For several reasons, the regulators struggle with proactive countercyclical enforcement and have been known to rely upon reactionary, rearview mirror remediation-based regulatory action.
Part of the countercyclical proactivity challenge relates to the political-based enforcement posture of the executive branch. Regulation is a) one part - a system of laws and b) another part - a regulatory enforcement posture of those laws. One example is the swing in enforcement posture of the Consumer Finance Protection Bureau (CFPB). During the Obama Administration, the CFPB enforcement posture was strong. It had the mandate to enforce consumer protection, especially those related to the Dodd-Frank Act. The Trump administration's enforcement posture changed, with an increased focus on consumer education, causing a dilutive effect on its earlier enforcement posture. While the Biden administration's enforcement posture is yet to be fully determined, early signs indicate an increasing enforcement posture. From CFPB Acting Director Dave Uejio:
"One thing we can do immediately is focus our supervision and enforcement tools on overseeing the companies responsible for COVID relief. I am concerned about the findings described in last week’s Supervisory Highlights edition that companies are failing to properly administer relief through the crisis."
Interestingly, the strength of the regulator is not necessarily a matter of needing new laws. The Dodd-Frank Act and the CARES Act are already on the books. This is a matter of the enforcement posture of the regulators themselves. I'm not taking a position on the appropriate level of the enforcement posture. Although, one could argue what is the point of having a law if the regulators are not going to enforce it. My point is enforcement should be consistent across time, economic cycles, and the executive branch's political affiliation. The fact that the bezzle increases or decreases based on whether the times are good or bad creates the challenge. It really should not matter. Reducing the bezzle inventory growth in good times will lessen the impact of economic downturns. One of the many lessons from the great recession is that an increasing bezzle can create downward momentum. Perhaps beyond that of the individual contributing factors. The problem with the bezzle is that it can create hard-to-see embedded risks in the banking system. For example, the circumstances related to the RMBS Settlement demonstrate the hard-to-see embedded risks that build the bezzle. The settlement alleged that many large banks "knew or should have known" the loans they were pooling for RMBS-based securities were not of the quality represented by their bond ratings. In retrospect, the factors driving the financial system collapse seemed obvious. At the time, those factors were often obscured behind the bezzle curtain.
"{a big bank’s} employees even referred to some loans they securitized as 'bad loans,' 'complete crap' and ‘[u]tter complete garbage.’"
Hence, in the bleak, economic depression time, the bezzle shrinks as trust falls. In John Maynard Keynes' view, it is up to the government to prime the pumps so all fare better to break a negative economic cycle. (2) However, as a society, we have not yet figured out how to break the cycle without increasing the bezzle. That is, we are in the habit of providing stimulus today that plants the bezzle seeds for tomorrow's economic downturn. Unfortunately, economic growth and the bezzle seem inexorably linked.
N.N. Taleb, in his book Skin In The Game, is wary of regulation. He believes regulation should occur because lawsuits are not effective.
“This doesn't mean one should never regulate at all. Some systemic effects may require regulation (say hidden tail risks of environmental ruins that show up too late). If you can't effectively sue, regulate.”
Again, my position is not related as much to regulatory levels as it is to consistency. If a combination of lawsuit and regulation gets us to an environment with reduced bezzle, then so be it. My concern though, is that lawsuits tend to be reactive. In the case of the financial crisis, did it make sense for millions of people to lose their homes and to have their retirement accounts decimated before lawsuit-based remediation occurred? Proactive regulation could have been helpful in this case.
Notes
(1) “At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”
- John Kenneth Galbraith
(2) In Zach Carter’s biography on JM Keynes (The Price of Peace), he makes an unintended reference to a broader definition of the bezzle, as related to Keynes’ view of the 3 political problems of mankind, namely, economic efficiency, individual freedom, and social justice.
“People had once accepted an unequal system because it had improved their lives (note: Keynes is referencing the Gilded Age just before WW1); because they had embraced it, the system had been able to generate prosperity. Now everyone from the coal miner to the investment house magnate had come to believe in a bleak, limited future (whatever the bankers said about the virtues of the gold standard, the paucity of actual investment in the economy was a more telling measure of their true feelings). That collective doom and gloom could not be broken by individual acts of courage.”
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