Goldman Sachs, Business Standards and the Critics

Goldman, Sachs & Co.'s release of its 67-page report of its business standards committee on proposed internal changes in practice has been met with skepticism -- with one exception. The Wall Street Journal Wednesday chose to interpret it as a sign that investment banking is making a comeback at the firm. The report "showed how Goldman is trying to reassert the traditional primacy of deal making while playing down the firm's recent reliance on trading. One of the bigger reasons why: Trading caused most of the turmoil, suspicion and reputational damage suffered by Goldman since the financial crisis erupted."

Alas, the paper puts forward a surprisingly flabby thesis. That last statement about blaming traders more than bankers is true -- although most of the nonfinancial world regularly fails to distinguish between "investment banking," "trading" and "Wall Street," or know what these folks do every day. Given the complexity of causes into the crisis, the notion that "trading caused most of the turmoil" is also a stretch. And the ascendancy of trading at Goldman was "recent" only if by "recent" you mean the late '90s, around the time of its public offering. Jon Corzine, trader, became CEO in 1994, which was a sign not of trading hegemony but temporary trading pre-eminence. By the new century, however, and despite Corzine's ouster by banker Henry Paulson, trading was providing, year in and year out, an increasing portion of Goldman's revenues and profits, often past 80%; a trader, Lloyd Blankfein, then succeeded Paulson. This renders Gerald Corrigan's statement to the WSJ, "I've always felt the kind of man- or woman-in-the-street point of view that... the securities side was dominating the firm was an overstatement," arguable, at best. Beside the fact that Corrigan, Paul Volcker's sidekick at the Federal Reserve and former New York Fed chairman who is co-chairman of Goldman's business standards committee, which wrote the report, is talking up his own book here, notice the haziness of that "overstatement," which can mean almost anything. As for his reference to the man- or woman-on-the-street, again, such every persons don't really know much about Goldman except perhaps what they got from Matt Taibbi in Rolling Stone. It's a straw person.

More substantively, given Goldman's size and its role as a public company, it's a little hard to imagine Goldman's banking group, which still boasts unparalleled coverage, generating the kind of results from "deal making" in a way to satisfy the quarterly desires of its shareholders, not to say employees anticipating high compensation. We at The Deal might wish that this was not the case, but M&A remains cyclical and competitive. Trading, at least as Goldman has pursued it, has greater flexibility and, as hedge funds have long argued and as the firm proved throughout the crisis, can make money in good markets and bad. Thus, one should be suspicious about talk of bankers getting their political mojo back at Goldman or, in fact, that the firm is about to return to, say, the '80s, when a "client-first" ethos actually still had a chance of being clearly articulated. Goldman was then much smaller and a partnership that defined itself as an adviser or intermediary. For a time it claimed to only practice M&A defense, a policy quietly abandoned by the '90s. Finance itself was smaller and simpler, and its conflicts were more straightforward. Today, the simple notion of "client first" presupposes that you can discriminate, prioritize and manage a bewildering number of customers with different interests on different parts of any given deal. It's not just a matter of Goldman's interest versus some customers; it's a matter of which customers to reward, which ones to hammer and which ones to pass silently by.

This explains the skepticism. In the Financial Times Thursday, Sebastian Mallaby, the author of More Money Than God: Hedge Funds and the Making of a New Elite, makes the argument "that these pieties [client first] misrepresent the true nature of the investment bank just as surely as the SEC did. A bank's first loyalty is to its profits, not those of its customers." Indeed, given Goldman's status as a public company, how could it effectively resist shareholder pressures to maximize profits, particularly when a large slug of those shareholders consists of employees? Mallaby goes on to make the point that the only way to eliminate some of these conflicts in a firm as large and as complex as Goldman is to break it up. Mallaby's scorn is palpable and over-the-top funny. "No amount of yogic incantation can harmonize these split personae; the solution is to break the banks into functional units, so that merger experts, market makers and proprietary traders no longer cohabit. A refashioned Wall Street of specialist boutiques would be healthier for customers. And since the boutiques would be smaller than today's megabanks, they might be small enough to fail."

Simon Johnson, in a post on The New York Times' DealBook, lacks the laughs, but ends up in much the same place: The real issue is size and shareholders, not declarations of new practices or power-to-the-bankers. Johnson has long called to break up too-big-to-fail banks, but, so far, Washington has ignored him. He now offers an idea floated by Mervyn King, governor of the Bank of England, and others that large financial institutions should increase their equity relative to the debt, thus in practice reducing leverage. This is a fascinating idea from a corporate finance perspective, if more debatable in the real world. Johnson argues, citing economists like Stanford's Anat Admati and the Bank of England's David Miles who have presented this argument, that adding leverage to a too-big-to-fail bank increases earnings per share in good times and insures a bailout in bad times. Johnson makes two key points. Size is important because only a TBTF institution will, in his view, be bailed out. And given the alignment of interests between shareholders and employees in a firm like Goldman, size and increasing leverage are inevitable.

As with much of Johnson's blogging (The Baseline Scenario) and book ("13 Bankers"), he can be both interesting and tendentious. So much of his case depends on what he sees as the absolute certainty of future bailouts for TBTF banks and the ultimately paranoid certainty that the fix is in. More bailouts may be coming -- or not. Those who believe in the efficacy of the resolution authority built into Dodd-Frank would certainly debate him on that point; but, like a sports argument, neither side can possible be declared a winner until we play the game. Moreover, as King and others admit, the standard argument against boosting equity is that it's expensive. Johnson and a number of other economists dispute that. This subject gets technical quickly -- but it's worth one thought. If I was a shareholder, I would be increasingly leery of buying stock in a firm that a) was eliminating the upside of leverage (or for that matter, given the firm's size, dependent on the vagaries of M&A) and b) continued to operate in a volatile business where there was even a slim chance that the equity would be wiped out. Like Warren Buffett, I would want a very good deal.

The truth is, this entire discussion is not really about returning to a golden past when morals were morals and clients mattered, or about some swing in power and influence from traders to saintly bankers. The real issues, which this report never really wrestles with, involve size, complexity and the role of shareholders and employees. As long as shareholders are pre-eminent, as long as even the hint of bailouts exists, as long as the rewards for winning are so great, financial institutions will remain large risk takers, and conflicts will persist, particularly, but not exclusively, between traders and bankers. What's fascinating here is that no one in this discussion, including Goldman, has tackled the broader subject of accredited or sophisticated clients, which in the real world has allowed so many of these ambiguities to blossom. The reason, of course, is that the notion of two tiers -- sophisticated and unsophisticated -- "works" for regulators and practitioners, but is a disaster politically. Corrigan's "man-or-woman-on-the-street" (really meaning their political representatives in Congress) doesn't "get" the murky ethical challenges of a dog-eat-dog world of sophisticated players or, in fact, why options are more limited for the less sophisticated crowd. (Indeed, that dichotomy only convinces some that the sophisticated are playing a rigged game designed to enrich themselves.) And since much that is going on here is a more aggressive defense of Goldman's image, not a deep restructuring of its business model, those ordinary folks referenced by Corrigan have to be acknowledged and massaged, at least for now.

Robert Teitelman is editor in chief of The Deal.