Posted on Saturday, January 15, 2011
To great fanfare, this week Goldman Sachs introduced the report of its business standards committee, which makes recommendations regarding changes to the internal structure of what is currently the fifth-largest bank-holding company in the United States. Some recommended changes are long overdue – particularly as they address perceived conflicts of interest between Goldman and its clients.
What is most notable about the report, however, is what it does not say. No mention is made of any issues of first-order importance regarding how Goldman (and other banks of its size and with its leverage) can have big negative effects on the overall economy. The entire 67-page report reads like an exercise in misdirection.
Goldman Sachs is ignoring the main point made by Mervyn King, governor of the Bank of England, and others: why big banks need to be financed much more by equity (and therefore have much less leverage, meaning lower debt relative to equity). In his Bagehot Lecture in October, for example, Mr. King was quite blunt (see page 10):
Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. They are responding to incentives. Some claim that reducing leverage and holding more equity capital would be expensive.
But, as economists, such as my colleague David Miles (2010) and Anat Admati and her colleagues (Admati et. al., 2010), have argued, the cost of capital overall is much less sensitive to changes in the amount of debt in a bank’s balance sheet than many bankers claim.
This King-Miles-Admati critique appears to be gaining a great deal of mainstream traction (for more on Professor Miles’s view, click here). At the American Finance Association meeting last weekend in Denver, there was much agreement around the main points made by Professor Admati and other leading finance thinkers who recently wrote with her to The Financial Times about this issue.
Professor Admati’s slides from her presentation on Saturday at the Society for Economic Dynamics (held in tandem with the A.F.A. meeting) are on the Stanford Web site. The paper that she wrote with Peter DeMarzo, Martin Hellwig and Paul Pfleiderer, also presented at the meeting, examines in depth, critically and in the context of current public policy, the mantra that “equity is expensive” for banks. At the same link are related pieces of varying length.
Reviewing any of these materials is an easy way to get up to speed on why Goldman Sachs’s internal reorganization is little more than irrelevant.
Or perhaps it is a thin smokescreen. The Goldman report does have one revealing statement (on page 1, under their “Business Principles”): “We consider our size an asset that we try hard to preserve.”
As John Cochrane, a University of Chicago professor and frequent contributor to The Wall Street Journal put it recently, “The incentive for the banks is to be as big, as systemically dangerous, as possible.”
This is how big banks ensure they will be bailed out.
This week’s Goldman Sachs report does not contain the phrase “too big to fail” or any serious acknowledgment that Goldman staff at many levels have the incentive to take on a great deal of risk – through increasing their leverage (debt relative to equity) in one way or another.
On this point there is already perfect alignment of insider interests with what their shareholders want – there is no conflict of interest to be addressed. As Professor Admati points out, when a bank is too big to fail, adding leverage raises the return on equity in good times (boosting employee bonuses and the return for shareholders) – and in bad times a bailout package awaits.
The Obama administration, House Republicans and banking executives like to frame the discussion about financial regulation in conventional political terms, with the “left” supposedly wanting more regulation and the “right” standing for less regulation.
But this is not a left vs. right issue. Professor Cochrane is not from the left of the political spectrum; nor is Gene Fama, who signed the Admati group’s letter to The Financial Times; nor are numerous other leading finance people who agree with this position (as the list of Admati signatories makes clear). Mr. King is a consummate apolitical technocrat – as is Paul Volcker, who has been hammering away at these themes for a while.
The financial sector captured the thinking of our top regulators over the past 30 years. It continues to exercise a remarkable degree of sway – as demonstrated in the very small increase in capital requirements agreed upon in the recent Basel III accord.
There was some serious pushback last year against the biggest banks from a few members of Congress – including Representative Paul Kanjorski and Senators Sherrod Brown, Ted Kaufman, Carl Levin and Jeff Merkley. (The epilogue to the paperback edition of “13 Bankers” reviews the details.)
Now top people in finance are taking broadly similar positions.
Our big banks have too little capital and are too large. Do not be deceived by the internal alterations and new forms of reporting put forward by Goldman Sachs. At its heart, the problems in our banking system are about insufficient equity in very big banks.
The case against increasing equity in the financial system is very weak – as the arguments of Mr. King, Professor Miles and Professor Admati explain.
Most of the opposition to greater equity is in the form of unsubstantiated assertions by people paid to represent the interests of bank shareholders (executives, lobbyists and the like).
There is nothing wrong with shareholders having paid representatives – or with those people doing the job they are paid to do. But allowing such people to make or directly shape public policy on this issue is a huge mistake.
By SIMON JOHNSON, THE NEW YORK TIMES