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.