Satyajit Das: Goldman Sach’s flawed model


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The Independent Online

The very public and sensational “exit” interview in the opinion pages of the New York Times by the former Goldman Sachs executive director Greg Smith is more than an expose of the alleged practices of his former employer. The criticism points to a deeply flawed system, including significant failures in regulation, which Goldman Sachs and other financial institutions have exploited and which remain unaddressed.

Central to this system is in-built conflicts of interest between acting in the interest of a client - “muppets” in internal Goldman Sachs lingo - and trading on the bank’s own account.

In the 1990s, investment banking shifted from a client focused business (providing advice, underwriting securities and executing purchase and sales of financial instruments) to a business trading on the firm’s own account using shareholder capital.

The change was driven by the growth in size and capital resources of investment banks, as they evolved from private partnerships into public companies or units of large commercial banks. It was also driven by shrinking margins on traditional activities, such as lower commissions and underwriting fees, and the need for new sources of revenue to meet investor return expectations.

Investment banks feared that the separation of client business and trading with its own capital would limit their ability to compete. Under CEO Lloyd Blankfein, Goldman embraced the conflict, emphasising intelligence from trading with clients and other banks to place bets with its own money.

Major investment banks sought to become “flow monsters”, capturing a dominant proportion of trading volumes to augment their proprietary activities. To achieve this, banks used cross subsidies to attract clients with significant trading volumes. Execution or market-making, credit facilities as well as financing for large hedge funds were provided at subsidised prices. In an insidious process, this created pressure to increase trading volumes even further as well as increasing reliance on proprietary revenues to meet shareholder return targets.

The best research was channelled to support proprietary trading. Client research increasingly became devalued, evolving into a sales aid, mere puffery, for selling products or the firm’s inventory to the clients. Products were designed and sold to assist investment bank’s proprietary traders to take positions, sometimes at the expense of clients unaware of the risks.

The shift was cultural as well as economic. As trading became more prominent, the path to Chief Executive passed through the trading floors. The trader culture is isolated from clients and highly results oriented.

When combined with the toxic ecology of bonus systems that emphasis short term revenues, banks evolved a transactional business model. Deals and profits dominated at the expense of client interests and longer term relationships, a practice known as “scorched earth banking”.

Following the 1929 stock market crash and the collapse of the banking system, the Glass-Steagall Act of 1933 sought to prevent some of these conflicts of interest. Removal of these regulations in the 1990s was crucial in allowing the development of this new banking model.

In the early 1990s, derivative scandals, such as Proctor and Gamble, highlighted the problem. The Internet stock boom exposed the practices of leading investment banks in relation to stock sales and self serving research. But despite numerous enquiries, the problem was not addressed.

In 2002, America’s Sarbane-Oxley legislation failed to address the real issue – the inherent conflict of interest inherent in “integrated” financial supermarkets combining commercial and investment banks. The proposed changes in regulation following the current financial crisis do not again adequately deal with the problem.

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the Volcker rule, seeks to restrict the ability of regulated entities to undertake proprietary trading, indirectly eliminating the conflict of interest. The efforts of bank lobbyists have ensured that the final rule will be considerably weakened and riddled with exemptions. One lawyer reportedly told banks that “given so much of proprietary trading has a client nexus to it, I'll be embarrassed if I don't manage to exempt all your activities from the rule“,

In the UK, the Vickers Report considered separation of certain activities of banks.  In the end, the commission did not recommend radical reforms, proposing instead to force banks to ring fence UK retail operations rather than split along different business lines.

Unless the central conflict of interest is dealt with, banks will always be tempted to give their own proprietary interests priority to boost earnings. In reality, the only way to deal with this is by separation of client and proprietary activities.

Greg Smith’s brave statement does not merely point to questionable behaviours at the investment bank, once tagged by Rolling Stone Magazine journalist Matt Taibbi as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. The alleged practices are widespread throughout the industry, where competitors ironically see Goldman Sachs as a role model. They are ultimately the symptom of a deeply flawed and dangerous model which there is a reluctance to challenge.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)