Sunday, March 18, 2012

Greg Smith on Goldman: An indictment of investment banking?

Greg Smith, the Goldman VP who resigned with a searing indictment of Goldman Sachs in the New York Times, has created quite a commotion. Predictably, the responses, which are understandably heated, have fallen into two extremes. On the one side are those who are predisposed to believe the worst about investment bankers and view this as vindication for their view that investment bankers are shallow, self serving and greedy. On the other are defenders of investment banking, who argue that this article states the obvious (that investment bankers are focused on making money) and that Greg Smith is a failed, middle level banker, having a midlife crisis.

I think I have the credentials to be on either side. On the one hand, many of my best and brightest students work at investment banks (including Goldman) and I teach training programs for both incoming analysts and associates at many of the investment banks. On the other hand, I have never been shy about critiquing investment banks for creating and marketing products that add little value or for providing self serving advice to some of their clients. In fact, I begin my corporate finance class with a clear statement that the class is not an "investment banking" corporate finance class but one that is structured around how businesses (who are the potential clients of investment banks) should make decisions. And I end the class, imploring students who do go into investment banking to preserve their options to abandon, if they find themselves unhappy with the grind or uncomfortable with the consequences of their actions.

Given that I have skin on both sides of the game, I want to look at the most troubling contention in Smith's piece, which is that Goldman Sachs bankers cared little about their clients and spoke about them with contempt. (To be honest, I am not sure what to make of "muppets" as an insult... I have always liked Kermit and have nothing but respect for Miss Piggy's self reliance...) After all, it is one thing to be cast as a ruthless money machine (a critique that has often been leveled at Goldman) and an entirely different one to be accused of ripping off your clients.

Do investment banks put their interests over the interests of their clients? I would not be surprised if they do, but before you are overcome by moral indignation, I would hasten to point out the following:
  1. The typical client of an investment bank is more likely to be a corporation, hedge fund or institutional investor than an individual. So what? These entities are not exactly shy about promoting their self interests and I will wager that, given a chance, they would not only exploit mistakes made by investment banks but also mistakes made by their own clients.
  2. The relationship between investment banks and their clients strikes me as mutually exploitative, and neither side can exist without the other's acquiescence. Let me use one example of the disfunction that is created as a consequence. There is strong evidence that many large M&A deals are value destructive for acquiring company's stockholders. While it is true the valuations from investment banks grease the wheels for these deals, it is also true that the managers of the acquiring firms are just as much to blame as investment bankers. Intent on spending stockholder money to gratify egos and build their corporate empires, these managers are less interested in honest advice from investment banks and more so in their deal-making prowess. In fact, I think that many corporations use investment banks as shields against having to take responsibility for bad decisions, with "It was not our fault, since the investment bank told us it was okay" becoming the post-failure refrain. 
Has this always been true? It was perhaps less so, four decades ago, when investment banks were almost all partnerships and catered to clients who did not shop around and stayed with their in-house banks. Before you become too nostalgic for the old times, remember that this was just as ruthless a world, where new competition was squashed quickly and becoming an investment banker was difficult to do, if you were not born into the right family, had the right connections or went to the right school.  The "old rich" were just as greedy as the "new rich" but they did do a better job of maintaining appearances. 

Rather than invoke the past or rail against the present, I would like to pinpoint at least three reasons why investment banks have become less client focused over time:

  1. Deal shopping: As Goldman gets excoriated for not being client focused, it is worth remembering that loyalty is a two-way street. In a world where clients play investment bankers off against each other, hoping to get the best deal for themselves, these same clients cannot point fingers at investment banks for playing the same game with them.
  2. Specialization: I do think that finance has become too specialized in both academia and practice, with experts and traders who know everything there is to know about narrower and narrower slices of finance or securitization. As a result, the people designing and trading new financial products/services have little sense of where these products fit into the larger scheme of things, and, as a consequence, when it makes sense to use them (or not use them).
  3. Compensation: I do not begrudge investment bankers their income or wealth, but I do think that investment banks have tied compensation too closely to deal making and trading success. By doing so, they have encouraged their employees to get the deal or trade done, often at a cost not only to clients but also to the investment banks in the longer term.
So, in case investment banks are interested in my advice on how to be more client focused, here is what I would suggest:

a. Hiring: Investment banks have always focused on hiring the best and the brightest and they should continue to do so. Some people, though, are better at seeing the big picture than others (think Magic Johnson on the basketball court or Joe Montana on the football field) and investment banks need to find more of these generalists to balance the specialists.

b. Incentives/ Compensation: Tie incentives and compensation more closely to maintaining long term client relationships and getting good deals/trades done. I know that this will be more difficult to do than the existing system, but it will healthier.

c. Clients/Customers: This may perhaps be the hardest part of the process, but investment bankers may need to be more picky about their customers, saying no to some, even at the expense of substantial profits. 

Not practical, you say! Well, someone has to start the ball rolling and that someone has to profitable and powerful enough to set the trend. Wait! I do have a nominee! How about Goldman Sachs? This may be the perfect time for the firm to announce a revamp of hiring and compensation structures and see if others follow. 

19 comments:

Tangent Style Storyteller said...

Fair points. Certainly better than the vindication and defensiveness of the two sides described in the post's opening.

sakusa said...

Hi Professor - the issues you highlighted are merely symptoms of a much deeper malaise - the lack of any sense of corporate values beyond the relentless pursuit of lucre at any cost. Not that it's unique to Wall Street, considering how many supposedly educated and well off people (and nations) just bankrupted themselves doing exactly the same!

Nor is it a new problem, as some argue, variously blaming Gramm-Leach, Greenspan, Bernanke, etc.

Here's Buffett's example from 1989:
"Our comments about investment bankers may seem harsh. But Charlie and I - in our hopelessly old-fashioned way - believe that they should perform a gatekeeping role, guarding investors against the promoter's propensity to indulge in excess.
Promoters, after all, have throughout time exercised the same judgment and restraint in accepting money that alcoholics have exercised in accepting liquor. At a minimum, therefore, the banker's conduct should rise to that of a responsible bartender who, when necessary, refuses the profit from the next drink to avoid sending a drunk out on the highway. In recent years, unfortunately, many leading investment firms have found bartender morality to be an intolerably restrictive standard. Lately, those who have traveled the high road in Wall Street have not
encountered heavy traffic."
http://www.berkshirehathaway.com/letters/1989.html

Richard Beddard said...

The problem with casting the relationship between investment banks and their clients as mutually exploitative is you make it sound like a game in which the only people that get hurt is the client or the investment bank. But that's not true is it? Ordinary people have an interest in restricting the games the play.

Aswath Damodaran said...

Sakusa,
Interesting that you should quote Warren Buffett, who is just as ruthless and profit minded as any of the investment bankers that he critiques. And what's wrong with businesses being single minded about profitability? Is that not the role of business? The wealth created from these businesses goes to their owners (stockholders) who can be as charitable as they want with their money. I don't want managers at companies being charitable with my money.

Aswath Damodaran said...

Richard,
Fair point. I was not talking about banking as a game but the back and forth on this issue as a game. You are right about side costs from the game playing but the side costs are not related to this issue (investment banks exploiting clients) but a different one (proprietary risk trading).

Aswath Damodaran said...

Richard,
Fair point. I was not talking about banking as a game but the back and forth on this issue as a game. You are right about side costs from the game playing but the side costs are not related to this issue (investment banks exploiting clients) but a different one (proprietary risk trading).

sakusa said...

Hi Professor - Buffett only threatens to be ruthless. Recently, when Sokol violated his insider trading rules, he proved toothless. Plus, he insists on not laying off longtime employees at one or two of his failing acquisitions.

As for business being single minded about profitability, my point was that the likes of Goldman are relentlessly pursuing lucre at any cost. That's a far cry from being single minded about profitability. It's more about sacrificing stakeholder trust.

In my book at least, that certainly isn't the role of any business I'd trust my money with.

Vetti said...

Really good article but I dont get your point about deal shopping.
For eg., if I let two real estate brokers fight it out to get me a good deal, how is it fair for them to (may be collude and) hide the fact that the house is on a sink hole (analogous to Greg's article where he describes that the IBank's offered bad investment choices) and take my money?

Minnebarista said...

Thank you, Professor. I left M&A and investment banking years ago to work in product development, finding no joy in it. Sometimes, spending time with my significantly wealthier finance classmates has me feeling less accomplished, but this boosted me up again. The lessons I learned from you about measuring and creating value I use almost daily in striving to create value for the individuals who entrust their money with us.

Francisco Viyuela. francisco@fviyuela.com said...

Great idea to touch on this very sensitive issue prof. Damodaran, not many public people are willing to state their views due to the large vested interests on this industry.
If you find it appropriate, I would like to ask your opinion on several other ways to improve the behavior of the financial services industry:

1- Enforce Chinese walls on investment banks. I have worked on 3 large US investment banks and 4 asset management firms and although all of them complied with all regulations, none of them had what the Chinese wall regulations were drafted for. It is still too easy for senior managers to comply with the letter of the rules and not it's spirit.

2- Separate in-house operations with in-house capital (prop trading, market making) from client money and client advisory business. Despite all the current regulations we still see how the same trader that takes positions on a market, advises outside clients on trades or builds products with the stuff he doesn't want to be sold to outside clients. Despite all the opposite from the industry to the Volcker rules and anything to do with Glass-Steagal, I think it will better align the interests of all involved. In the UK they are doing something even more ambitious, trying to ring-fence commercial banking from commercial banking financed investment banking operations.

3- I would go even further on your compensation comments to have all variable compensation payable in a materially delayed way (4 years & up), and always in the form of equity, not cash. After all the "I won´t be here, you won´t be here" behavior, I think it is really needed. Also, listed companies with a large base of minority shareholders have proven to be too focused on quarterly results to be able to have the appropriate focus on long term clients & shareholder interest. A move back to more employee owned companies might help to align everyone's interest again.

4- Give real power to compliance, risk managers, auditors and internal control people. I have yet to see a senior manager in an investment bank stand by the risk manager whenever a big revenue generator is involved. This conversations usually end with the manager defending a questionable practice on the grounds that the guy involved generated more revenue than the budget of the risk management group. The other way they end is by telling the risk manager that his bonus pool comes from the revenues generated by the guy who he is trying to impose some limits on. These are not isolated incidents on the banks I've worked for, this is business as usual in the industry, only it doesn't get printed on the New York Times editorial pages that often.

I don´t agree with the way Greg aired his concerns nor his motivations on why he did what he did but I think it was long over due that someone raised these issues to the general public.

wavedeva said...

I would like to comment on the concept of "maximizing profits". Yes profits should be maximized but the maximization has to be tempered with social awareness. For example, a baby formula manufacturer could dilute the ingredients in its products, but this would have an adverse impact on the health of babies consuming the product. Consequently businesses cannot "maximize profits" to the fullest extent possible. That is how we got into the financial mess that we are in now.

Furthermore, I find it a bit disingenuous that people complain about Goldman Sachs but not about Apple's treatment of its retail sales force in the U.S. and the high prices of Apple products. I was astounded to learn that the Genius Bar employee I was talking to just made minimum wage.

Anonymous said...

Professor, as you have admitted, you do business with Wall Street and you have close connection to the Wall street crowd. Hence, it is likely that you will have a biased opinion. However, one cannot hide the truth for long.

I have one word (long word) for you and the readers:
http://www.frankpartnoy.com

He is a professor, who formerly worked for Wall Street and resigned in disgust. He vividly explains how the Goldmans and Morgan Stanleys collude with Foreign governments to rip the citizens. The Wall Street has played a big part in Greek bond shenanigans.

I have read two of his books. I encourage your blog readers to check them out. It is time to spread the truth.

Anonymous said...

In my opinion is funny that people critique Investment Banks to think of profits first and clients second, when most main street companies do the same.

Would you say that a company that hires Goldman shouldn't have a CFO that understands completely what the terms are?

Do main street companies hesitate that much by changing a component from a machine to a cheaper one, for example, even knowing the quality is worst? (my parents had a washing machine that last 20 years, it finally broke for good. The second one last 3 years).


I guess we're facing a period of time where profits come first, even though it might be bad for the long run of the company. Time will tell whether this strategy is the winner, and if it isn't, the companies who first acknowlegde it will get a head start.

Joel said...

Hi Professor, can I check with you why expected equity return drops more than the risk-free rate when there's a shift to an aging population?

Investment Bankers said...

I appreciate your kind words.Investment Bankers have become leeches that cause sores on Investors' portfolios!! Thanks!!

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QUALITY STOCKS UNDER FIVE DOLLARS said...

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