Let Goldman fail next time

By Edward Harrison On Oct 22, 2009

John Gapper had a good piece in the FT yesterday called “Goldman should be allowed to fail.” His conclusion is that Goldman is allowed to game the system. It is a broker-dealer masquerading as a bank. It takes on much more risk than a traditional bank. It engages in different activities. It compensates its staff differently as well. And it is too big to fail. Gapper says this cannot be tolerated.

So, if Goldman Sachs took on more risk when its equity was held by outsiders than with its partners’ own money, what can we expect now that the government implicitly accepts that it is “too big to fail”? Goldman has an even bigger incentive to risk other people’s money.

This is the problem I identified last week, with the most powerful broker-dealer on Wall Street having the same privileges as the most mundane commercial bank. Not only does the fact that it may pay $23bn in bonuses this year upset people, but also its incentives are skewed.

Solving this requires two things to be addressed. First, Goldman’s intention to operate as a institutional Wall Street firm – complete with its own hedge and private equity funds – while having government and Fed support. Second, its tradition of setting aside half its revenues each year for employees.

Gapper also points out about Goldman Sachs is that the firm is very different than the one that went public in 1999. Back then sales and trading was only a third of revenue, however by 2006 and 2007, the fixed income and currency divisions were up to two-thirds of revenue. This year, in the first nine months, those units have contributed nearly 80 percent of the firm’s revenue.

In Goldman’s defense, Gapper admits that the firm is the most partner-like of all the big Wall Street firms.

Goldman probably has one of the most partner-like pay structures for its managing directors. About two-thirds of bonuses are in restricted stock that vests over four years and its most senior partners have to hold 75 or even 90 per cent of the stock until after they retire.

Gapper doesn’t believe that is enough and suggests returning to a system in which 90% of Managing Directors’ money is tied up in the firm until retirement.

Now, to be sure, Goldman has a huge cushion of $170 billion in cash for events like the ones we witnessed last Fall. It is commonly considered the best run firm on Wall Street. But it is still a broker-dealer.

One thing Gapper fails to mention is how a large balance sheet necessarily translates into bigger bonuses. A lot of people have made the argument that big banks are so big because they benefit from economies of scale in activities like derivatives and they need to compete in cross-border activities. But, the dirty little secret in corporations is that the larger a company is, the more revenue and profit it makes and this justifies much higher compensation for senior staff.

Imagine for a second you have eight firms on one side with revenue of $1 billion and profit of $100 million each and one company on the other side that is just as big as the eight collectively with revenue of $8 billion and profit of $800 million. Who do you think makes more money, the guy running one of the eight companies or the guy running the large one?

Size matters not just in economies of scale or competition but in paychecks as well.

In any event, Gapper believes that Goldman should not receive the benefits of the federal reserves discount window unless it is a true deposit-taking institution which carries out a central function that carries responsibilities. The suggestion is that Goldman should be stripped of its bank holding company status unless it takes on these responsibilities. And if it gets into difficulty in the future using this same broker-dealer business model, Gapper says Goldman should be allowed to fail.

Goldman should be allowed to fail – John Gapper, Financial Times