Much has been written about the so-called “Abacus” deal in which Goldman Sachs brokered the sale of subprime pools of securities. The US’ Securities and Exchange Commission has accused Goldman of not informing buyers on one side of the transaction about the fact that some of the securities they were sold were shorted by a hedge fund manager. The US Congress has been quick to wag a finger at Goldman, accusing it of breaching fiduciary duty. Whether such accusations have merit is worth examining because it appears that other investment banks may also face similar allegations.
Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd.
The current allegations reflect a simplistic approach to this issue. First, it has been pointed out by senior Goldman officials that markets exist because people on both sides of a particular trade have different views. In almost all situations, intermediaries are not obligated to disclose all possible information, including their personal views, in the course of a transaction. In almost every financial or commodity market, intermediaries also have proprietary positions. The motivations that underlie intermediation are always likely to be a desire to profit at the expense of the counterparty. In their book Freakonomics, authors Steven D. Levitt and Stephen J. Dubner illustrate how real estate agents frequently sell their own houses at prices higher than what they get for their clients. Yet no one accuses realtors of systematic breach of duty.
Market-makers such as Goldman provide liquidity by facilitating various kinds of transactions, and they are partially enabled by taking proprietary positions and perhaps selling these later at a profit. The entire framework of market capitalism would erode if market-makers were expected to only enable trades that met certain fiduciary requirements.
As Warren Buffett has also pointed out, anyone trading with a large financial institution should know there is an information asymmetry in the transaction. Large financial institutions have much greater depth and breadth in the market than many other institutions, and the position that such an institution can take will almost certainly be better informed than any other counterparty. One should not be surprised if large organizations such as Goldman win more often than they lose.
But most of all, what causes concern is the almost supernatural disconnect with reality demonstrated in the arguments against the banks and the disregard for conflicts of interest and distortions of incentives that exist in various parts of the market until a serious crisis occurs.
For instance, an allegation made during the dot-com boom was that some investment banks, while recommending certain stocks, were themselves offloading those shares. Similarly, there has always been a somewhat naive belief that the commercial and investment banking arms of financial institutions maintain a rigid Chinese wall between themselves although there has often been evidence that these walls are porous. It has always been known that audit firms have sought to obtain substantial non-audit fees from their clients. Astonishingly, it was always believed until Enron that independence could be retained despite this conflict.
Instead of such wilful credulity, it would be far more useful to recognize the dangers of playing in these markets. All those dealing with financial intermediaries should perhaps be made explicitly aware that intermediaries can stand on different sides of a transaction and that their interests could often be widely divergent.
One hopes that by pressing charges against Goldman Sachs there will not be a shift in attention from the real regulatory changes that ought to be in place. While it is publicly popular to attack banking institutions (and there are indeed many egregious violations of risk management and general corporate governance that banks could be hauled up for), selling potentially loss-making products to an institutional investor is not one of them. In this light, it is important for us to not shift focus from the real issue—the need for lower levels of leverage, greater capital requirements, and greater visibility of counterparty positions.
Govind Sankaranarayanan writes on issues related to governance.
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