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27 April 2012, Gateway House

Investment banking and the muppet conundrum

The author discusses the incriminating Op-Ed published in the New York Times on Goldman Sachs bank and analyses the investment banking world critical situation. He outlines many initiatives and advocates for bilateral reform policies that could be an important first step in addressing the situation.

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Greg Smith, a former derivatives salesman at Goldman Sachs resigned from his post on the same day that he published an incriminating Op-Ed on his now-former employers, in the New York Times. It’s not difficult to see why. There has been much anxious hand-wringing in the investment banking world (and gleeful hand-wringing in the media) over Mr. Smith’s exposé of what he calls Goldman’s ‘toxic’ culture, in which employees are rewarded for ‘ripping eyeballs out’ and in which Managing Directors write off customers as ‘muppets.’

Lloyd Blankfein and Gary Cohn, the CEO and President of Goldman Sachs respectively, maintained public silence in the immediate aftermath of Smiths’ article, despite the writer’s accusation that the two had “lost hold of the firms’ culture on their watch.” However,  Blankfein allegedly sent a memo to Goldman’s staff soon after, reiterating the firm’s customer focus and discrediting Mr Smith’s views. Jamie Dimon and James Gorman, the respective heads of competitors JPMorgan and Morgan Stanley, followed by exhorting their employees not to bad-mouth Goldman Sachs to mutual customers. Messrs Dimon and Gorman ostensibly felt it would be unseemly to use the article to belittle a competitor. A cynic might however have surmised that Dimon and Gorman could too easily empathise and hoped that, in taking the high road on this occasion they might save face themselves in the future. Mr Gorman’s words : “There but for the grace of God go us” made this somewhat apparent.

Though Mr Blankfein insists that Smiths’ article does not reflect the reality of Goldman’s corporate culture, a long series of scandals and missteps seems to corroborate the latter’s perspective. The mortgage derivative misselling for which Goldman was fined US$550 million by the SEC; the   conflict of interest which the bank maintained in advising on the merger of El Paso and Kinder Morgan; the bank’s assistance to Greece in the deception of Eurostat about the countries’ borrowing levels in off-market currency swaps; the alleged blackmailing of Unicredit, in which Goldman kept company with none other than Morgan Stanley and JP Morgan – are just some of the instances that have recently come to light in which Goldman appears to have firmly prioritised its own interests over those of its clients or the wider world.

However, very little of this should truly shock us. Goldman Sachs, like any investment bank – like any business, for that matter – exists to make money, and money is made when one party takes it from another. In the case of investment banks it is through the margin and fees taken on financial transactions. Goldman’s clients would undoubtedly prefer to lose as little money through financial transactions as they can, while on its part the bank is likely to try making as much money as possible for itself through the same transactions. This while keeping a balance between short and long-term benefits of profit, and legality. Goldman would not be alone among banks in this regard.

It seems to me there are only two points worth much discussion here. The first: Has Goldman Sachs got the balance wrong between short-term profit and long-term damage to its corporate reputation? This is a purely commercial question for the company to answer on its own and should be of little interest to the wider public. The second, and arguably more important, question is: Do investment banks today have too much freedom to make money at the expense of clients who have little means to fight back? If so, how can a fairer balance between the well-being of banks and that of their customers be established in the future?

This is an important point. Too often, those who pay the price for bad deals cut by investment banks are those who can least afford it. In the mortgage misselling case, the value of the missold paper collapsed soon after it was in the hands of parties representing some of the most vulnerable end investors. Among the purchasers affected in that case were Local Authorities and Pension Funds like ABP, which provides retirement income to government and education sector employees in the Netherlands. And while the misleading Greek swaps were by no means the sole contributing cause of the country’s financial crisis, they certainly exacerbated it. Now ordinary Greek citizens are paying the price, and they will probably continue to do so for years to come.

How, then, can the balance be restored? Let’s look first at the factors that increase the scope for high rents in modern day investment banking:

–      The complexity of a number of ‘products’ in the industry means greater scope for high hidden charges. If customers don’t know how much money a bank takes and what lower-cost alternatives exist for an equivalent service, then they have little power to insist on fairer treatment.

–      Products like over-the-counter derivatives (Mr Smith’s area) are currently most typically traded as bespoke products, the prices ofwhich cannot be readily compared with market benchmarks. Price comparison is made even more difficult by confidentiality agreements that banks sometimes insist on customers signing which prevent the latter from sharing product details with the bank’s competitors.

–      There are strong arguments made by bankers for customers to avoid obtaining price comparisons in some instances (for example, in the case of trades done to support sensitive M&A transactions where information entering the public domain – such as through obtaining a competitive quote – could adversely effect movements in market prices of shares and thus jeopardise the underlying M&A transaction), but this privacy could result in certain banks charging higher fees than might otherwise be justifiable.

–      The universal banking model creates opportunities for high gains at the expense of vulnerable customers. It can often be easy, for instance, for a bank to take disproportionately high margins for investment banking products from small corporate customers or Local Authorities which, due to their size or nature of staffing, lack a sophisticated understanding of investment banking and are easily confused by jargon and false justifications for inflated prices.

–      Substantial rewards for a bank’s staff often follow near-term gains made by the bank in question; this practice drives a culture that values maximum revenue from transactions currently ‘in the bag’ rather than those which may provide better value for the customer but which involve a longer gestation period for the bank in earning its revenue.

–      This system of remuneration in the industry tends to attract staff who are highly motivated by large personal gains which are made quickly – exacerbating the problem.

Another key question to address before moving on to potential solutions is: What should we consider a ‘fair’ rent for trading services? This is, in many ways, a much more difficult question to answer than that of how to change the revenue balance between banks and their customers. Perhaps the best standard to apply might be ‘those levels that are achieved in a market which has as much transparency and competition as practicality will allow.’ Unsatisfactory? In many ways, yes, butI am open to other suggestions.

So what are some of the things that can be done to increase transparency and competition, thereby bring the investment banking industry closer to ‘a
verage’ business norms?

Global regulation to simplify instruments and make pricing more transparent whilst retaining the key benefits to customers of the said instruments might provide a good start. A coordinated global effort requiring as much derivative business as possible to be traded on exchanges and settled through clearing houses, for instance, would substantially increase transparency of pricing these instruments. By definition, derivatives traded on an exchange need to be far more standardised than off-exchange or so called ‘over-the-counter’ derivatives, resulting necessarily in greater standardisation of prices. This, in turn, makes it easier for bank’s customers to track fair market prices. Clearing houses require parties to periodically post collateral based on the marked-to-market value of the instrument being traded. If the majority of trading is settled through clearing houses, deviations of prices quoted by banks from fair market prices will be far more apparent to customers.

A more formal separation in the banking business between those sections of a bank dealing with customers and those that trade in markets would reduce bank’s scope for taking advantage of sensitive information obtained from customers. Global regulations to prevent banks from trading for customers and their own accounts simultaneously, the model for the putative Volcker Rule, should also have a beneficial effect in this respect. Moves toward separating retail and commercial banking from investment banking services within banking institutions would reduce the scope for misleading unsophisticated customers.

Reform initiatives for staff remuneration could help move firms away from an unduly high focus on discretionary pay and toward greater rewards for consistent long-term performance. Reforms could also include provisions that allow banks and regulators to withdraw previously paid bonuses in light of long-term developments.

Some countries are already taking action along these lines. Elements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, expected to be implemented by the U.S. later this year, address each of the above areas. Likewise, The Independent Commission on Banking in the U.K. (also known as the Vickers Commission) has recommended the legal separation of retail banking units from the investment banking arms of U.K. Banks. The European Commission has proposed a financial transaction tax that would apply to trades done by banks in all of the EU’s 27 member states. France has pre-empted the EU by unilaterally legislating for the implementation of a similar tax within France. These last two proposals aim to reduce the quantum of speculation in financial markets, which should have a beneficial ‘knock-on’ effect on customer abuse.

Still, a coordinated international approach has been noticeably lacking. While unilateral action by individual countries is useful in highlighting the key issues and potential solutions, such action will do little to substantially change the status quo. In the absence of multilateral reform policies, potential offenders could easily circumvent new regulations by shifting their bases of operations to places with less stringent policies.

Perhaps the best place to begin coordinated reform would be the G-20. Members of the group include Finance Ministers and Central Bank Governors from 20 major world economies that collectively account for more than 80% of global GNP, 80% of world trade, and two-thirds of the world’s population. The G-20, therefore, has the reach, influence and seniority not to be undermined by individual member countries. While final resolutions could emerge from the G-20, background work could be delegated to specialised groups like the International Organization of Securities Commissions (IOSCO), The Joint Forum, or The Basel Committee on Banking Supervision.

India is well positioned to play a major role in reform efforts within the G-20. Indian regulators, credited with India’s relative immunity to the worst effects of the recent financial crisis, have gained much respect within the G-20 in the last few years. By taking a proactive role in forming a coalition to establish multilateral banking reform, India could further enhance its reputation as a global leader in pragmatic banking reform policy.

Enacting some of these reforms on an international scale could be an important first step in establishing greater equality between the banking industry and some of its clients, which we currently lack. In time, perhaps it could also inspire a culture in which being fair to clients is valued as highly as making money off them – or at least one in which customers aren’t customarily referred to as ‘muppets’ on bank trading floors. The financial sector is, at its core, a world of profit, driven by ambitious, sometimes ruthless men and women. We can hardly expect some sort of altruistic en masse conversion, nor would we want one. Judicious reforms, though, could help to temper some of the baser instincts revealed in Mr Smith’s editorial, and confront more effectively the abuses in a system within which some participant’s priorities have outpaced the law’s capacity to restrain them.

Karan Bhagat is the former Managing Director and Country Head of Barclays Corporate in India.

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The author discusses the incriminating Op-Ed published in the New York Times on Goldman Sachs bank and analyses the investment banking world critical situation. He outlines many initiatives and advocates for bilateral reform policies that could be an important first step in addressing the situation.