Goldman Sachs, Greg Smith And Market Regulation

Mar.14.12 | About: Goldman Sachs (GS)

The public resignation letter in the New York Times by Greg Smith of Goldman Sachs (NYSE:GS) accusing the firm of putting its own profits ahead of its clients' interests is generating a lot of buzz today, for a variety of reasons.

To me one of the most interesting lines was this: "It astounds me how little senior management gets a basic truth: If clients don't trust you they will eventually stop doing business with you."

If this is true, it suggests the power of customers, rather than government officials, as the ultimate regulators.

I'm not necessarily sure this is as "basic" a truth as Mr. Smith suggests. If it is a basic truth, the most important truth in the sentence may be "eventually," which can be a period of time during which Goldman Sachs makes a lot of money.

Here are a few scenarios in which clients would do business with a firm they don't trust:

1. The firm offers other valuable things other than trustworthiness.

2. There is no competing firm offering a similar level of other services and products at similar prices with a higher level of trustworthiness.

3. The client thinks that it can compensate for Goldman's lack of trustworthiness by other means, such as watching them carefully, or hiring consultants to watch them carefully, or crafting legal contracts robust enough to handle a business agreement with a non-trustworthy partner, or aligning interests with them in such a way that the client and the non-trustworthy Goldman folks are teaming up to make money together from someone else (a la John Paulson and Goldman versus the European banks).

I'm not advocating doing business with a firm that one doesn't trust. Obviously, if everything else is equal, one would rather do business with a firm one trusts than with a firm one doesn't trust. I think what Mr. Smith is saying is that investment banking customers are probably sophisticated enough to realize that trustworthiness is one of the things they are buying, and the investment banking business is competitive enough that if firms do badly enough on the trustworthiness front clients will eventually leave. That's a sharply different thing from saying that the government needs to step in to protect Goldman's clients from being ill-served by their own bankers. In other words, Mr. Smith's criticism of Goldman is to some degree a market-oriented one, which, at least to me, makes it somewhat more credible than it would otherwise be.

As for the rest of the piece, some of the terminology ("muppets"?) was new to me, but the idea that investment bankers might put their own interests ahead of their clients goes way back to probably before Fred Schwed Jr.'s Where Are the Customers' Yachts? was published in 1940.