There’s yin and yang at Goldman Sachs

The Financial Review

PUBLISHED: 24 Mar 2012

Anna Bernasek, New York

At one time or another most people dream of writing a scathing resignation letter, excoriating a boss or a company that seems out of touch with good business principles. But by any standard Greg Smith wrote one for the ages when he resigned publicly from Goldman Sachs by writing a piece in The New York Times.

So far there have been two reactions to Smith’s principal allegation that Goldmans rips off its clients. For some, a Goldmans “executive” finally spoke the truth about the firm’s moral bankruptcy. But for others, Smith’s letter was a juvenile reaction to a completely normal situation in a tough, competitive business.

The letter certainly touched a nerve. Many people, including some finance professionals, agree with Smith’s critique. Just think about the implications for a moment. How could the world’s pre-eminent financial institution have succeeded by ripping off its clients? Is that even possible?

Well, maybe.

First of all, Goldmans didn’t become the world’s leading investment house without doing a lot of things right. Before its ascendance, names like Morgan Stanley and First Boston reigned on Wall Street while Goldmans remained a smart, scrappy outsider. Goldmans plugged away at the industry for decades, hiring the best and brightest and outworking the competition.

But success is a mixed blessing. It brings greater scrutiny, and greater arrogance. When you’ve made it there’s less reason to worry about what people think. Your mentality changes when clients are competing for your attention. Not too long ago when the IPO market was booming, having Goldman Sachs as lead underwriter on your company’s offering was a mark of distinction. With that kind of power and reputation comes enormous temptation to extract profits even at the risk of losing long-term relationships.

And not all clients are created equal. There are clients that Goldman cares about deeply, providing superb value and service with an eye to the longer term. And then there are clients it can live without. Clients who are clueless, small, or with one-off needs are potential targets for less stellar treatment.

Goldmans certainly doesn’t gouge all its clients. But it’s a safe bet it makes decisions about each client and how important it is.

Then there are the clients who don’t mind being ripped off. Some people who are in the business of managing other people’s money are willing to buy mispriced or faulty products because they can personally benefit. By exploiting accounting rules investment managers can show good results in the near term even if over the longer haul things don’t pay off. For some clients the appearance of value is worth paying a lot for.

Whether financial “innovation”, complex securities, proprietary products, or illiquid markets, Goldman Sachs can be found in the areas where money is being made. And the bulk of Goldman’s clients – corporate management and investment fund managers – are stewards of other people’s money. The firm works hand in hand to make those managers look good, with mutual rewards. Executive pay, and in particular the pay of money managers, has skyrocketed; so have finance industry profits. But company profits, and investment performance, hasn’t matched the growth rate in pay.

Goldmans reinforces a culture where the people in charge get paid far above anyone else, with pay closely linked to stock prices. Meanwhile, it and other banks work hard to come up with schemes for companies to boost their share price.

Take M&A for instance. There is a long-running debate on the benefits of mergers and acquisitions as a strategy. It seems that for every spectacular success there’s a spectacular failure. Looking at aggregates over time, the benefits are not particularly clear. But it is clear that management tends to get paid a lot for doing M&A. And so do the advisers, of which Goldman is one. Whether other stakeholders are doing well doesn’t seem to be a prime concern.

Then there’s all the illiquid, complex and opaque financial instruments Goldmans provides that can obscure a company’s performance or give the appearance of profit.

Goldmans looks after its customers well, at least the ones that matter. But often the relationship between the firm and its client is between two individuals. It’s between the banker and the hedge fund manager, not the underlying investors. So while the banker provides excellent service on an individual basis that might not be in the interest of either the client’s institution or the public at large.

One day another scrappy outsider will unseat Goldmans from the top spot. Unless Goldmans focuses on building trust more broadly, that might happen sooner rather than later.