Goldman's Rise in a World Without Responsibilities
Does the shift to transactional banking explain the many downsides of the finance business?
- In the modern shark tank, every medium-sized company, every dozy municipality, had to build itself a fully fledged finance capability.
- Under traditional relationship banking, the client itself did not need to be particularly financially sophisticated.
- With the move to transaction banking, the only deals where you didn't have to compete were ones where you had devised some complex derivatives structure.
- Competing solely on price may initially have looked attractive to clients, but was highly destructive to the ethical standards in the financing business.
Under traditional relationship banking, a banker had more or less exclusive dominion over a client and consequently was held, mostly by market custom, to have a fiduciary duty both to that client and over its operations.
This relationship meant that the client itself did not need to be particularly financially sophisticated. It could rely on its relationship banker to advise it on the best course of action and to arrange any transactions that for operating reasons it wished to undertake.
This all changed from the late 1970s with the move to transaction banking. Under transaction banking — an aggressive, sales-driven approach to the financial services business emanating from the United States — there were no longer any client relationships.
Every transaction was competed for on the basis of price. The only deals where you didn't have to compete were ones where you had devised some complex derivatives structure that others didn't have which was irresistibly appealing to the client.
Otherwise, it was a matter of who gave the financing at the lowest cost in debt deals, or at the highest issue price in equities. Since investment banks are not fools, there was little competition within the U.S. investment banking cartel over the bloated commission spreads on equity issues.
This may initially have looked attractive to clients, but in reality it was highly destructive to the ethical standards in the financing business.
No longer could clients rely on their merchant/investment bankers to give them good advice, or to protect their interests in general. That meant that every medium-sized company, every dozy municipality, had to build itself a fully fledged finance capability, if only to guard against the piranhas in the finance pool.
The losses suffered by Procter and Gamble and Orange County in 1994 demonstrated quite early on the dangers of operating with a finance staff that was less sophisticated than the sharpies of Wall Street. Needless to say, this additional staffing was extremely expensive for the economy in general, while bringing little benefit in terms of real value added.
The changes the new order had brought were illustrated very early, in the derivatives activities of the UK local authorities. By 1983, interest rate swaps had become a well-understood tool, and so swap dealers went round the UK local authority finance departments selling them.
Since they had no fiduciary relationship with the clients, they dangled before the dumb, but greedy, local finance officers the possibility of lowering their borrowing costs by swapping their fixed rate debt into floating rate debt. Of course, while saving money in the short term, that dumped a load of interest rate risk on local taxpayers.
The solution is for the financial services business to revert to an advisory model rather than a transaction model, in which the bank arranging the deals has at least a modest fiduciary duty to its client. It is of two types: One is to assure the welfare of the client itself, recommending transactions that benefit the client and avoid those that don't. The other fiduciary duty is to prevent that client from ripping others off.
Goldman Sachs in the 1980s were advisors to Robert Maxwell, at a time when he was looting the assets of the Daily Mirror pension fund. To the extent Goldman knew about Maxwell's activities, they had a duty to impede them. They certainly had a duty to avoid transactions that assisted Maxwell in his depredations.
Similarly, in the case of Italian local authorities and the Greek government, banks had a duty not to assist local politicians in using obscure financial market transactions to falsify their accounting or to load risks either onto future local taxpayers or onto EU taxpayers as a whole.
Reverting to relationship banking is easier said than done. Trading activities of all kinds have been so profitable in the last 30 years that only a lunatic would suppose the major financial institutions will retreat from them easily.
The move away from transactional banking and back to a relationship system is thus likely to be gradual. However, it is so clearly in the interests of both clients and the global economy as a whole that we can hope it is inevitable in the long run.
Editor's Note: This article has been adapted from Martin Hutchinson's essay "The Downside of Transactional Banking," which appeared on The Bear's Lair on March 22, 2010.
Martin Hutchinson is the co-author of “Alchemists of Loss” (Wiley, May 2010).