Last week the internet and major news media were both abuzz with the public denunciation (in the pages of the New York Times) of Goldman Sachs in an “I quit!!” letter by a mid-level executive. The Goldman employee, named Greg Smith, who worked in London selling derivatives to hedge fund clients, charged that the firm’s culture had changed dramatically for the worse in the twelve years he worked there, that many of its employees regarded its clients as suckers, or in the British parlance, “muppets,” and that conflicts of interest and self-serving behavior had not only become the rule there, but that they were being encouraged by fellow employees and by the firm’s managers. He took the firm to task for violating its supposed motto, “clients first.”
While there was a lot of piling on by those who agreed with his dim view either of Goldman in particular or of investment banking in general, and an ample amount of Schadenfreude from those who did not work in the sector, there were many who either jumped to the defense of the firm, or who essentially met the accusations of the employee, by arguing that investment banks had always been that way, and always would be, because that was the nature of financial markets businesses. In essence, they were saying that all dealings with investment banks are conducted at arms’ length by knowledgeable individuals who are trying to take advantage of each other, that no securities firm has any obligations to its customers other than to deliver whatever securities are agreed upon at the negotiated price, and that caveat emptor has always been and should always be the law of the financial marketplace.
This last argument is wrong, and dangerously cynical for two reasons: it assumes that all financial services businesses are akin to open-market trading, and it assumes that every participant in those markets knows as much as every other, or at least, ought to. On the contrary, the investment banking business is extremely diverse and includes many activities which are nothing at all like the horse-trading of listed securities for a short-term gain, and the survival of effective markets depends upon both the efficient bridging of asymmetries of knowledge and the maintenance of specialists who can serve as sources of knowledge and providers of services which depend upon that specialization. The problem is that all of these services have been brought together under one roof because of the economic advantages of size and access to low-cost capital, and because too many participants in the industry labor under the notion that they are not only smarter, but more knowledgeable than anyone else in the room.
The existence of such highly-paid middlemen as investment bankers suggests that they serve some purpose. It was of course possible, so long as the stock exchanges had a monopoly on transactions and could limit memberships, while at the same time having the power to expel anyone who engaged in price competition, for stockbrokers—as well as anyone whose business dealings would ultimately involve a stock or bond market transaction—for these middlemen to extract rents. But that cozy arrangement crumbled years ago: by 1985 it was substantially gone in the United States, and one year later, it was voluntarily disbanded in the UK, and shortly thereafter, in France and other countries with developed capital markets. Moreover, a tremendous amount of capital went searching for returns by investing in the intermediaries those same capital markets. Interestingly, despite so much money chasing returns in the same place, while (as would be expected) it drove margins in traditional activities almost to the vanishing point, it did not decrease the industry’s profitability, and especially not for the employees paid by those same investors who had ended the old markets’ cozy cartel. That should suggest that, somehow, they were able to add value.
This was despite the fact that more and more studies kept coming out which demonstrated that it was difficult, if not impossible, for anyone to beat the market consistently, especially on a short-term basis, which would suggest that the advice and informational advantages supposedly enjoyed by financial intermediaries were of little value. Moreover, many of the clients of the financial intermediaries were also under severe financial pressure, while others (corporate clients in a stock market and economic boom) were of such relative financial strength that they were able to put pressure on the investment banks’ margins anyway. But—despite many ups and downs for their owners—the banks and bankers were able to claim an increasing proportion of overall profits in the economy. Either the new combinations of all the formerly separated financial businesses were incredibly powerful, or thanks to the synergies now inherent in financial services, their rapidly rising numbers of employees were increasingly valuable, or both. Certainly, the exponentially rising incomes of so many employed on the Street, in the City, and in their counterparts elsewhere in the world, would seem to require that one way or another, employees were adding value.
As middlemen, brokers, corporate financing specialists, and traders have always enjoyed being at the center of a nexus of information unavailable to other participants in the financial markets. The new, universal investment banks exploited this position to the hilt, and in an increasingly complex and interrelated financial system, despite increasing transparency, and the development of new and increasingly democratic means of exchanging information, the informational asymmetries remained and even grew. Thus, it was worthwhile for users of the financial system to continue to pay for the services of bankers, and it was worthwhile for the owners of banks to pay for the employees which made the system go. The problem is that the shortest cut to the greatest profitability was to exploit the asymmetries to the principal or sole benefit of the bank itself. And this was new: before, it was the long-term relationship with the well-financed client which was the basis of making money on Wall Street: the bank took a steady cut of the cash flow, which had to continue if the bank would remain profitable. But now, it has become more profitable for the firm to compete with its own customers.
As one reader in the Financial Times aptly put it, the defenders of Goldman (and critics of Mr. Smith as being hopelessly naive) assumed that the patient should know as much about medicine as his physician, understand automobiles as well as any mechanic, and know as much about plumbing as the plumber he calls in to fix broken pipes or a leaking toilet. Leaving the first example aside perhaps, because it involves one of the learned professions, and a whole host of professional certifications no layman can be expected to have, the reader had a very good point: we all have every reason to expect a certain duty of care whenever we deal with any specialized business we pay to supply a particular service. This is the whole point of having a non-subsistence economy with divisions of labor. This is why licenses are required for so many service businesses, stockbroking among them. Far from being typical, trading is actually an outlier in the financial services industry.
Portfolio managers, for example, may believe themselves to be exceptionally well-informed, wired into all sorts of information networks, and financially sophisticated. But they cannot and should not know what their competitors in the marketplace are doing and saying at any particular moment, because they are not in a central position, but on the periphery, and because they are competitors. If an institutional salesman whom they know and have been dealing with, from an established firm, calls them and tells them that a particular security is behaving in a particular way, or that his customers seem to be adjusting their preferences with regard to securities selection or attitudes toward risk, this information may or may not add value, but it should not be deliberately deceptive. The same is even more true for an initial offering of a new security, where the law has imposed various rules about what must be disclosed, and various other rules about how any non-factual information (e.g., forecasts and projections) must be presented. The portfolio manager would be a fool to take whatever they are being told as gospel, and not to check on the information given, to make sure that it is in accord with or at least does not contradict something they know to be true, and to be aware at all times that there will normally be a bias in favor of action in whatever the salesman is recommending. But the portfolio manager also knows that the salesman has access to information which the PM does not, and that without such sources of information, they are flying blind with respect to the marketplace. Similarly, the corporate financial officer needs to know about the market conditions into which their company may be contemplating issuing new securities, buying back their existing ones, or considering the purchase of another company. Some of this information can and should be verified using internal personnel doing their own research and collecting their own data, but it would be absurdly inefficient and prohibitively expensive for every investor and every issuer to have a complete investment bank in-house, and such an operation still would not be able to replicate the information flow available to a market middleman dealing with hundreds of market participants every day.
The situation is exacerbated in the case of financial innovations, which have been appearing at an ever-increasing rate, despite the fact that many of them have been discovered to have hidden flaws not apparent when they were first employed. The PM, or the CFO may actually be as smart as they think they are, and they still should have no reason to be expected to fully understand every complex new financial device or strategy being marketed to them. One alternative is for the prospective customer to refuse to deal in anything which is not old and familiar, and there is much to be said for such conservatism, but there are also opportunity costs attached to such an approach, and the pace of change in markets may leave those restricting themselves to such a strategy in the position of losing clients, as well as opportunities. So, like it or not, the investor and the issuer alike must deal with the investment bank at less than an arm’s length, and this implies that a certain amount of bona fides is demanded of the bank as well.
For many years, some firms had an interest in being more ethical than the rest, because of the exceptional value of their franchises—like the old “bulge bracket” underwriters—or because of their reputation as advisors, either to corporate clients or to investors. The quality of the client list was all-important, and the key to the individual banker’s value at that time was his share of the relationships he brought to the firm. Wire houses—which depended upon a retail clientele spread around the country—and trading firms did not enjoy the luxury of such long-term and usually exclusive relationships. Goldman Sachs was a relative newcomer to these elites (there had been some murky and embarrassing scandals in the 1920s, even by the gamy standards of that time), but through the boom years of the 1950s and 1960s, the firm’s franchise improved, it survived the stressful years of the 1970s with its reputation intact, and by the 1980s, Goldman was part of the “bulge bracket” itself. Some firms successful in those years became known for being hungrier, and some for exploiting their broad distributional base to buy their place at the table, but Goldman managed to expand its franchise by being known as both smarter, and to a large extent, more ethical than the other newcomers. For example, in the increasingly brutal field of m&a, the firm made much of its reputation for mounting successful defenses of companies under attack, and therefore refused to act on behalf of a hostile acquirer.
As trading-oriented firms, such as Salomon Brothers, with their bruising culture of blatant self-interest, increasingly began to dominate the industry, Goldman kept its bankers in the forefront, its traders in the background. When the other firms went public and sometimes sold themselves three or four times over to ever-richer bidders, Goldman remained independent, and a partnership. They fostered an image of cruising above the fray, because they were better, smarter, and therefore could afford to be more ethical. But the banking business was becoming ever-more deal-driven, and client loyalty had become a thing of the past. A critical moment was reached when Goldman decided to stop turning down would-be hostile bidders, and another was reached when traders began to be promoted to senior managerial posts. Finally, the firm ceased to be a partnership at all, but sold itself to the public, removing the last barrier to any sort of common internal interest—all of its competitors had of course long since taken the same path. Henceforth, Goldman traders and other risk takers would be playing with shareholders’ money, rather than their own.
As Goldman expanded its business model, and became increasingly involved in various aspects of the financial markets as a principal, rather than as an agent, the potential for conflicts grew, and often their reality as well. Customers became more and more aware of the disconnect between the supposed Goldman ethos and the reality of personnel who were increasingly looking out for their own benefit entirely, and the customer’s almost not at all. At the same time, Goldman became the most vigorous and visible defender of the status quo thanks to their unparalleled links to government, the fruit of former partners who had become key members of several Administrations, and the many ways they had shown of favoring their former firm.
Thus, the current model for investment banks, which is employed by almost all of them, is rife with conflicts of interest. As the defenders of the industry point out, some of these would be inherent in any model of the financial services industry, and indeed have always been with us, but in the past these tended to be self-limiting: rent extractors who were too ruthless began to lose customers, and actual fraud was eventually punished. Many of the conflicts of interest which are so profitable today, however, are specifically a byproduct of the broad spectrum of services these banks offer, which include proprietary trading, private equity investment, fund management, institutional and private client brokerage, primary broking for hedge funds, m&a, and underwriting. Not all of these businesses can cohabit without there being serious and potentially insoluble conflicts. Until and unless banks decide what business they are in, and whether they are going to be acting primarily in the interest of the client or primarily in opposition to it, these stories will continue, and cynicism will only grow, within and outside these firms.
Goldman is now getting clobbered in the court of public opinion not because they are uniquely conflicted but because they are (a) the most successful firm on the street, (b) have attained enormous political influence, and (c) have been one of the most hypocritical about denying the possibility that such conflicts exist. They will continue to be subject to such bad publicity until and unless they choose—as they were once forced to in the past—to emphasize either their advisory and agency businesses, or their proprietary ones. Perhaps the lure of profits will continue to triumph over the desire to have a good reputation. But the danger, aside from the risk that business begins to flow to other firms using other business models, is that public outcry will continue to rise, that Goldman’s political links will ultimately prove unable to counteract the pressure, and that regulation and legislation will reduce or destroy the profitable model the existing investment banks are using. Worse, there is the risk to the public that financial markets may be crippled in their functioning through such a punitive and retributive process.