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A decade ago, when Goldman Sachs was a private partnership, it had $6.5bn in equity and its 220 partners, most of whose money was tied up in the firm until they retired, took good care of their pot of gold.

The bank’s trading and principal investing division – the part that took the most risks with partners’ capital – was balanced with its fee-based investment banking and asset management divisions. Trading contributed about a third of its revenues in the two years leading up to its 1999 initial public offering.

After it sold shares in the IPO to outside investors – pension and mutual funds hold about 80 per cent of its equity – it steadily increased its appetite for risk. Its fixed income and currency division has become dominant, bringing in two-thirds of Goldman’s revenues in 2006 and 2007 (and 78 per cent in the first nine months of this year).

In last year’s crisis, the US government made clear that it stands behind Goldman and other big investment banks. It received a $10bn (€6.7bn, £6.0bn) capital injection from the Treasury (since returned) and $21bn of its debt is backed by the Federal Deposit Insurance Corporation. It is now a financial holding company whose regulator and lender of last resort is the Federal Reserve.

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.

On the first point, Goldman’s status strikes me as untenable. It may be better regulated by the Fed than the Securities and Exchange Commission but counting it as just another bank, with the same privileges and obligations as retail banks and credit card companies, makes little sense.

This is not to accuse it of being reckless, or insouciant about how it operates. It navigated the crisis best of all the investment banks and does not run itself as if it is bound to get bailed out. It is well capitalised and holds $170bn of cash and liquid assets to hand, just in case.

Nor is it merely a giant hedge fund. Its pure proprietary activities make up about 10 per cent of its revenues. Market-making in bonds and equities, now its main business, serves companies and investors, although it is a capital-intensive and sometimes risky activity.

But its business is different from the banks for which the discount window – the Fed facility that allows its regulated banks to borrow cash in exchange for securities in extremis – was invented. Until recently, no one would have suggested that Goldman deserved a place with them.

Mervyn King, governor of the Bank of England, put it well this week. The “utility aspects of banking where we all have a common interest in ensuring continuity of service are quite different in nature from some of the riskier activities that banks undertake, such as proprietary trading”.

One possibility is for Goldman to spin off its activities that come under the latter heading: the hedge funds and private equity investments in which it risks capital. That would leave its market-making activities and investment banking divisions as a high-class financial utility.

Even then, it should not be treated by the Fed like a retail bank which has its deposits guaranteed and is, as Mr King phrases it, “too important to fail”. Goldman must be structured and regulated in such a way that it could safely be allowed to fail in any future financial crisis.

This would address some of the justifiable public anger about Wall Street firms having been bailed out by taxpayers, but what about the second point: Wall Street’s lavish rewards to its senior employees?

The bonus problem in investment banking is not the absolute size of the rewards (although shareholders ought to ask themselves if the employees really are worth it) but the incentives they create.

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.

That is one reason Goldman has navigated the financial crisis better than others, but it could still learn from its past. By returning to the system of locking up all (or 90 per cent) of its managing directors’ bonuses until they retire, it would make them even more careful.

If taxpayers could see not only that Goldman’s bonuses were a form of equity partnership, but also that the bank would be allowed to founder in any future crisis, it might sap some simmering resentment.

Alternatively, Goldman could keep its old riches and newfound official status, keep on taking more financial risk, and try to square the circle by convincing people that it is a utility that operates in the public interest. That might be a struggle.

john.gapper@ft.com
More columns at www.ft.com/gapper

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