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Associated Press/Photo by Mark Lennihan

Bad influences

Business | Changes in investment banking have created strong temptations to sin

Issue: "Agony and ecstasy," April 7, 2012

On March 14, Goldman Sachs executive Greg Smith sent the investment bank a very public resignation letter-in the form of a New York Times op-ed. Unlike the bank he had joined 12 years earlier, Smith complained, Goldman no longer "revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients." Now, the only thing that matters is how much money can be made off the clients.

Wall Street insiders immediately dubbed Smith's jeremiad "the shot heard round the world." Although there is more than a little hyperbole (and self-importance) in the label, Smith's resignation has highlighted a very serious moral crisis on Wall Street. This is the latest blow to Goldman's reputation: It comes after a Rolling Stone article denounced the firm as a "vampire squid" and the SEC sued it for failing to tell clients they were purchasing mortgage-related securities selected by a hedge fund that was betting they would fail.

The jolts to Goldman's reputation have mesmerized Wall Street precisely because Goldman always claimed to be, and seemed to be, different than the dog-eat-dog banks around it. It claimed to be immune from the trends that have transformed investment banking in the past generation. The key difference is structural: In the old days, investment banks were all partnerships; in the 1980s, they became corporations.

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The change was important for two reasons. First, investment banks were desperate for funding because they increasingly were making money by trading for themselves, rather than by providing advice for clients. Selling its own stock was a great way for an investment bank to raise the money it needed for this trading. Second, becoming a corporation meant that the bank's executives were not personally liable for its obligations, as the partners of a partnership are. This meant that executives could take on more risk, and possibly make a great deal more money, without being personally responsible if their bets went bad and the bank failed.

Goldman held out longer than any of the other big banks. When it finally took the plunge and converted to a corporation in 1999, Goldman insisted that its unique culture would survive the shift. For a time, many people thought it had. But Smith's op-ed is the latest evidence that it didn't. Many argue that Goldman needs changed hearts, and must shift its focus back to making profits without taking advantage of clients.

Surely this is right, but it's also important to remember how Goldman and the other banks got here. The changes in investment banking have encouraged the change in behavior. Catholics call an environment that puts a person in the way of temptation the "near occasion of sin." This is what investment banking has become.

It's probably not possible to go back to the days when investment banks were partnerships whose partners put their reputation and their own bank account on the line every day. But regulation-or the absence of regulation-that encourages bankers to roll the dice should be revisited. As bad as they are, the recent financial reforms could help by adding more oversight of the complex financial contracts that have caused so much trouble.

Sharp business practices will never disappear altogether in a fallen world. But the Smith op-ed is a reminder that character matters, and so does the environment in which our financial transactions take place.

-David Skeel Jr. teaches corporate law at the University of Pennsylvania

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