It’s Not Just Goldman Sachs

Goldman Sachs
Goldman Sachs

Based on sheer tonnage of tweets, Greg Smith’s resignation from Goldman Sachs via a New York Times Op-Ed touched a raw nerve. He accused Goldman of a pretty serious offense: Not caring about its clients. Smith bemoaned the changes he perceived at the firm during his twelve years there.

Whether Smith’s view of Goldman is accurate is now a topic of fervent debate. It may be that Smith is onto something that is not specific to Goldman — a sea change on Wall Street.

While it’s popular to say the change is the result of unfettered greed, in fact, the seeds were probably sown by clients — the very ones Smith says Goldman doesn’t serve.

To get the full picture requires looking at the financial world just before Glass-Steagall was repealed. The law was intended to keep banks from investing customers’ deposits in the risky business of securities underwriting. But commercial banks had been chipping away at the law for 30 years. By 1999, the year the law was repealed, banks were already lending and underwriting to the same clients. They were risking their balance sheets on behalf of clients in every way they could.

Securities firms had to respond or lose their business. Clients wanted their financing bundled, because loans plus underwriting usually meant cheaper cost of funds. Most Wall Street firms were too small to compete with the likes of JPMorgan or Citigroup in this way. So they went public to boost the size of their balance sheets and support risk-taking for their institutional customers. Goldman Sachs went public in 1999, the year before Smith joined the firm.

With more capital, Wall Street expanded the risk it could take on and the services it could offer to clients. It could buy up bigger positions from institutional clients who wanted to get rid of an investment fast, without sending the share price into a nosedive. It could better support bond and commodities trading. These were all good things for clients, and made a lot of money for the firms that could provide them.

As clients demanded more of the balance sheet, the nature of the relationship with the firm was bound to change. Clients rely on Wall Street firms to take the other side of a trade. There is no doubt this new relationship creates conflicts of interest. A trading firm is motivated to make a good trade for its own account, which benefits shareholders, as well as perform a service for its client.

Certainly in the case of Goldman Sachs, clients who are trading partners take this conflict in stride. They say they expect a firm that takes the other side of a trade to have the opposite view from theirs. Clients also acknowledge pressuring Goldman to do a particular trade, and say that Goldman does a good job. “Greg Smith doesn’t change the way we view the firm,” says Mark Lasry, founder of $12 billion hedge fund Avenue Capital. “In all our dealings with Goldman, we found them ethical and proper.”

Ironically, clients say Goldman and other Wall Street firms are becoming more ruthless about which clients they want to do business with. This gets back to changes in compensation. Firms are deferring pay in an effort to ensure that bankers create the most possible value for shareholders. Across Wall Street, firms are measuring performance in a more quantitative way, looking at the longer-term returns of individual business units, and even individual trading desks, to justify pay. Employees in the most profitable businesses will get paid the most. That means they are more ruthless about cutting relationships that aren’t profitable. That’s what shareholders want to see.

“In the past you did research and all sorts of things for the benefit of the client,” said one client who uses several securities firms. “Now they can tell me if I’m in the top 10 relationships, or top 20. If you drop out of the top 50, they’ll tell you we’re not one of our top clients, we can’t just do stuff for you.”

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