By Simon Johnson
To great fanfare, this week Goldman Sachs unveiled the report of its Business Standards Committee, which makes recommendations regarding changes for the internal structure of what is currently the 5th largest bank holding company in the United States. Some of the 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. There is, in fact, no mention of any issues that are 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 of the debate made by – among others – Mervyn King, governor of the Bank of England, regarding why big banks need to be much more financed by equity (and therefore have much less leverage, meaning lower debt relative to equity). On p.10 of his Bagehot Lecture in October 2010, for example, King was quite blunt:
“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 (see this link for more on the Miles’ view). At the American Finance Association (AFA) meeting last weekend in Denver, there was much agreement around the main points made by Professor Admati and the leading group of finance thinkers that recently wrote with her to the Financial Times on this issue. Professor Admati’s slides from Saturday are on the Stanford website (she presented in a Society of Economic Dynamics session, running parallel to the AFA). The Admati, DeMarzo, Hellwig, and Pfleiderer paper examines in-depth, critically, and in the context of current public policy, the mantra that “equity is expensive” for banks; this is available online – on the same page you’ll also find related pieces of varying length. Reviewing any of these materials is an easy way to get up to speed on why Goldman Sachs’ 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 puts it, “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 there is a bailout package waiting.
The Obama administration, House Republicans, and banking executives like to frame the discussion about financial reform 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. John Cochrane is definitely not from the left of the political spectrum; nor is Gene Fama, who signed the Admati et al letter to the Financial Times; nor are numerous other leading finance people who agree with this same position (again, see the list of Admati signatories). Mervyn King is the ultimate 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.
The was some serious pushback last year against the biggest banks from a few members of Congress – including Congressman 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 King/Miles/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 (i.e., 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.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.