Why banks will continue to rip off clients

By Felix Salmon
March 16, 2012
Frank Partnoy makes a great point: the word "client" has been over-used by investment banks so much that by this point it "has become Orwellian doublespeak".

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Frank Partnoy makes a great point: the word “client” has been over-used by investment banks so much that by this point it “has become Orwellian doublespeak”. But the problem is much deeper than one of semantics. When all counterparties are considered clients, then that creates a corporate culture where all clients are considered little more than counterparties. And that, in turn, can be evil and poisonous.

Partnoy says that “the firm’s salespeople know who is a client and who is a mere a counterparty”, and to a certain degree he’s right. A sovereign wealth fund dealing with the equity derivatives desk is a counterparty; a private individual whose money is being managed by Goldman Sachs Asset Management is a genuine client. If you’re paying Goldman fees, you’re quite unlikely to be called a “muppet”, and no one in the firm is going to try to “rip your eyes out”.

But that doesn’t mean that Goldman will always be acting in your own best interest, rather than its own. Stockbrokers, famously, receive substantial fees from their clients, but don’t have a legal fiduciary duty to those clients, and do have a demonstrated tendency to steer their clients into the investments which end up paying them the highest commissions.

And even companies paying for M&A advice are sometimes victims of Goldman’s conflicts.

In other words, no one can complacently assume that they’re a favored client of Goldman Sachs and that therefore Goldman will be ripping off others on their behalf, rather than ripping off its own client. Not even people writing large checks to Goldman every quarter.

I’ve been talking to bankers in the days since Greg Smith’s op-ed came out, and there’s a pretty much unanimous feeling that bankers’ loyalty to clients, at least at Goldman and other big investment banks, has been declining across all aspects of the business, for many years.

Greg Smith was in equity derivatives — an area where it’s incredibly easy for salespeople to hide fees if they’re inclined to do so. In fact, it’s so much easier for a bank to build its fee into the pricing of complex bespoke products than it is to charge that fee directly, all banks do exactly that. It’s like buying “commission-free” currency when you go on holiday: you know full well that the bureau de change is still making money; it’s just making that money by giving you a bad price for your dollars, rather than by charging you a high commission.

But in a business devoted to making ever-increasing sums of money, it’s very easy for those hidden fees to get bigger and bigger over time. I talked to one former equity derivatives executive a couple of days ago, who said with surprising vehemence that in his day, the big clients were God: you built in fees, yes, but you never ripped them off or tried to steer them into something which was not in their best interest. Now of course what he was saying was self-serving, but I think it had an element of truth to it, too.

There’s been a lot of talk in the past couple of days about how Smith was not much of a star at Goldman: he was the sole person trading US equity derivatives in London, which is always going to be a marginal job at best, and he hadn’t risen very far up the greasy pole given how long he worked at the firm. Certainly it’s a bit of a stretch to call him an “executive” at Goldman, as that term is generally understood: he didn’t even have any employees. But at the same time, his relatively lowly position in the company is entirely consistent with a tale of a smart but ethical professional who didn’t make as much money for the firm as his peers did, just because he didn’t rip off his clients to the degree that they did.

All of which is to say that it’s worth taking Floyd Norris’s concerns seriously about the latest spate of deregulation in the securities markets. I think that there’s a lot to like in the JOBS act, especially the idea that we should stop forcing companies to go public just because they have 500 shareholders, including employees. Companies should be encouraged to give out equity to their employees, without worrying that if they do so, they’re on some kind of IPO train which can’t be derailed.

At the same time, however, there’s a lot of deregulation in the JOBS act which seems aimed primarily at giving banks a greater opportunity to make money, largely at the expense of investors in the primary markets. Mary Schapiro has some strong and important points: the primary markets are rife with information asymmetries, and someone needs to protect the interests of investors, rather than allowing banks to rip them off with legislated impunity.

All big banks are public companies. Public companies are always under a lot of pressure, from their own shareholders, to grow. But as a country, we have a public interest in seeing those banks shrink. The tension is clear. And if regulators try to get banks to shrink, the banks in turn are going to make even greater efforts to extract the highest profits possible from the businesses they retain. Which is another way of saying that they’re going to rip off their clients even more. So let’s be assiduous when it comes to regulation, because neither banks nor their boards are going to lift a finger to protect client interests. Not when they’re trying to maintain and maximize their own profitability.

29 comments

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Good piece Felix.

I also thought this was much fairer to Greg Smith than in your previous piece, being it took a lot of guts to air what he said even if he was leaving feeling disgruntled. (knowing he wasn’t going anywhere because he was more ethical must have been very disheartening)

His future is at stake by having written it, even though he didn’t have the guts to do it while still employed. Employees remain mum about such things for many reasons, some have something to do with saving your own hide, far too many with advancement, greed and bonuses.

Sadly I felt your last opinion was far too akin to this drivel, written by the Bloomburg “editors” which tries over-the-top misdirection to downplay the damning look at Goldman.

http://www.bloomberg.com/news/2012-03-14  /yes-mr-smith-goldman-sachs-is-all-abou t-making-money-view.html

Someone like Bloomburg protecting “their own” is quite enough, thanks very much! It is obvious Gordon Gekko was a fictional character in name only.

http://www.forbes.com/sites/briansolomon  /2012/03/16/bloomberg-backs-goldman-sac hs-over-ex-employee-op-ed/

Posted by youniquelikeme | Report as abusive

youniquelikeme, I guess anyone who spouts your line must be “moral”. Helps not to know what “OTC equity derivatives” actually consists of. Basically, the majority of the business is based around tax and regulatory arbitrage. His job consisted of allowing people to get round their tax obligations, hide debt by pretending it is actually equity, punt on risky equities when your investment mandate says risk-free fixed income and sell holdings whilst pretending you are all in, stuff that I am sure would normally outrage you. The guy basically stayed at the same level for 12 years in the midst of two major bubbles, I strongly doubt he had a future to stake. Now he can make money as a “whistleblower”.

As for clients, you have it round backwards. What happened is clients stopped being loyal to banks. A major investment bank tried to develop into an agency model in the late 90s and early 2000s and the CEO got fired as a result of clients dumping them, a depressed share price and massive underperformance. Where did those clients go? To places like Bear Stearns and GS. Bear Sterns bankrupted itself bailing out the lenders to their structured products hedge funds when those funds went under and those lenders immediately lost the BSC telephone numbers. When MS got into trouble post LEH bankruptcy it was because those clients immediately dumped them and started whipping out their money from the prime brokerage. Hands up people who are loyal to a mutual fund that underperforms for two straight quarters.

There is a difference between a client and a counterparty. A client is someone who is dealing with an investment advisor who has a fiduciary responsibility. A counterparty is simply owed an accurate description of what he or she is buying.

Posted by Danny_Black | Report as abusive

Danny Black, does that mean anyone who spouts your line is then “immoral?” Ah yes, former banker, that just may well be.

I didn’t pretend at all that I am all in…speaking of masters of misdirection. Whist grabbing at that strawman, note I was saying he was more ethical… and courageous to be putting his future in jeopardy (which you then repeated and twisted) … I doubt he acted at all purely given he worked for an investment bank. I am applauding his exit from it, however.

There is no doubt in my mind that the culture of banks and investment banks has been one that is unethical and
shirks its duties, but it is getting even worse exponentially.

There is no doubt in my mind that greed is behind the culture and always has been. Greed begets greed … be it client or bank. That you have defended Goldman from the beginning is no surprise. That you think it is OK to sell a bag of excrement knowingly to “sophisticated” investors (like pension plans?) and call it an accurate description is also typical. Some emails and the muppet remark are more accurate, but those weren’t relayed to the customers.

Principles for business (Goldman’s are below; more complete in the PDF to follow) not being adhered to is the point here:

“Goldman Sachs business principles reflect a set of ethics that are ingrained in our firm’s character. Our business principles reinforce our belief in ‘client first’ in all we do, and serve to guide our people in their daily interactions with clients and each other.”

Our clients’ interests always come first.Our assets are our people, capital and reputation. Our goal is to provide superior returns to our shareholders.
We take great pride in the professional quality of our work.
We stress creativity and imagination in everything we do.
We recruit the best person for every job.
We offer our people the opportunity to rapidly move ahead.
We stress teamwork in everything we do.
The dedication of our people is an important part of our success.
We consider our size an asset that we try hard to preserve.
We strive to anticipate our clients’ changing needs.
It would be unthinkable to breach a client’s confidence.
We must always be fair competitors.
Integrity and honesty are at the heart of our business.

http://www.gs.com.au/documents/about/Our BusinessPrinciples.pdf

Posted by youniquelikeme | Report as abusive

Right Felix, “Which is another way of saying that they’re going to rip off their clients even more…”
So, we better not trust those big greedy banks because they are just going to take our money and run!
Get a real life and stop the ranking about those smart people who ripe off stupid ones… Have you no sense of “personnel responsibility”? Do you think all those people who invest in those big banks are stupid, or is that Felix is just blowing hot air!!!

Posted by lucky12345 | Report as abusive

@lucky, It isn’t so much that ALL the clients of big banks are stupid, but that big bank employees prey on the ignorance of those who know less than they do. It’s very much a predator-prey relationship, not a guide-traveller or an advisor-client relationship.

If you can’t see the ethical bankruptcy of using knowledge against people instead of for them, you’re part of the problem.

Posted by FifthDecade | Report as abusive

FifthDecade, except that, unlike GS, their clients have a legal fiduciary responsibility to check the investments they make.

Posted by Danny_Black | Report as abusive

Well, does GS – or any other IB – have a “fiduciary duty” of care to its “clients”? If so, just who are the clients and do they know who they are – and who they aren’t?

If I’m doing business with someone in a position of confidence (a bank or broker of any type) and that person/firm considers me “fair game”, that should be made clear to me – in writing and before the transaction is executed.

Posted by MrRFox | Report as abusive

MrRFox, if they are an investment advisor then they have a duty of care. If you are a trading counterparty then they don’t and it is in the reams and reams of contracts you sign when you start doing business.

Posted by Danny_Black | Report as abusive

@ Mr. Danny Black,

Sir, the non-clients (the counterparties) know and appreciate that GS et.al. consider them prey animals, do they? Got that all nailed down in writing, right? No doubt at all in the minds of the chumps on the losing end of GS-packaged deals?

Assuming that so, then just admit the truth of brother Smith’s allegations – GS picks the pockets of its customers – serves ‘em right. Dare ya’.

Posted by MrRFox | Report as abusive

MrRFox, they aren’t “customers”, they are counterparties. In something like a swap it is typically a zero sum game. The counterparty makes money, GS loses and vice versa. I would be surprised if any counterparty of GS thinks that GS is not expecting to be the side making money.

Posted by Danny_Black | Report as abusive

Mr. Black – you’re arguing the ethical case (to wit: is it OK for GS to stack the deck in its favor against its “counter-parties” on the other side), by saying – “Yes, that’s kosher”.

Good, now that we have that settled – does GS stack the deck improperly in its favor? In your view, is it even theoretically possible for GS to take “too much” out of the hide of a counter-party that hired GS to set-up a deal?

You do realize what the fallout is going to be, don’t you? – corporate CFOs are going to have a hard time justifying doing business at all in this area with GS, now that it’s admitted that GS is dealing from the bottom of the deck. Those corporate officers have fiduciary responsibilities to their shareholders, even if GS insists it has none to anybody.

Posted by MrRFox | Report as abusive

MrRFox, I don’t believe that CFOs honestly think that when they do a trade with GS that GS is making a loss. Again very simply if I make X, my counterparty makes -X. Typically what I am doing is hedging that risk so that if I lose X then someone else is paying me X. There are of course cases where the customer is happy to lose X because they are buying certainty their losses can never be more than X or because they will lose more than X if they don’t do the trade. For example, an airline agrees to sell tickets at a set rate months in advance but if oil prices go above a certain rate they will go bankrupt so they hedge and maybe oil prices go down but they know that they are not going to be taking a loss on those tickets. Or a rich customer buys an equity swap because if he sells the stock outright he has to pay capital gains but this way he gets less than the market value but more than what he would get after tax if he sold it outright.

Posted by Danny_Black | Report as abusive

You don’t seem to “get it”, Mr. Black – or care to, for that matter. Now that it’s out in the open that GS’s own (former) people are admitting to ripping-off their derivatives counter-parties, the CFOs of the world are going to be under the microscope if they do any more of these deals with GS. Their lawyers are going to insist that every aspect of every deal be documented by evidence that it is “fairly priced”.

Can the GS derivatives desk survive that kind of examination?

Posted by MrRFox | Report as abusive

MrRFox and you think that they were just taking GS’s word for it before?

Posted by Danny_Black | Report as abusive

Mr. Black – Smith alleges that counter-party clients had no clue of the magnitude of fees they were paying, and others back him up on this point. Moreover, many of the contracts reportedly forbid the customer from seeking another opinion on the “fairness” of the pricing, and the offer would be void if the customer sought to get one.

Face it, guy – those practices(and the fat GS paydays they generated) are gone forever in this line of business, and others too, one hopes.

Posted by MrRFox | Report as abusive

MrRFox, none of the contracts “forbid” the clients from seeking another opinion on the “fairness” of the pricing. What they are not allowed to do is go to all of GS’s competitors and tell them hey in a few weeks time we are going to do this trade with a major counterparty feel free to front-run them. There are plenty of “independent consultants” who price these products. There are plenty of software products that price them.

You know quoting the greek deal isn’t a great example given that in return for a loss of 5 bn EUR Greece got to borrow at a fraction of what their real rate should be for over 5 years. I can 100% guarantee they saved more than 5bn over that time. For Greece those swaps were the deal of the century.

This is why journalists should be forced to not fabricate crap because idiots like you then turn round and quote them. Do yourself a favour and read to the end of the original Bloomberg article on the greek swaps.

Posted by Danny_Black | Report as abusive

Well now, Mr. Black – seems it’s more than GS that has crossed an important, if invisible, line in the sand.

Their salad days of picking pockets with impunity thankfully appear to be on the way to extinction, despite the best efforts you and others of a certain persuasion. And your days of masquerading as a serious person not reduced to name-calling is history as well.

Score it a double-play – for the “good guys”.

Posted by MrRFox | Report as abusive

MrRFox, yeah right. Let me make a more accurate prediction for you. Come the next bubble, you will be begging, offering to sell your first born in exchange for a chance to buy at the top of the market and just as surely when you lose money you insist it was never your fault and some silver-tongued salesmen convinced you that ratemypoo.com was really worth 500bn USD.

Posted by Danny_Black | Report as abusive

No doubt about it – you’re a class act, Mr. Danny Black – got “Wall Street” written all over you, lad.

Posted by MrRFox | Report as abusive

MrRFox and apparently you are one of the “muppets” Mr Smith’s boss was talking about.

Posted by Danny_Black | Report as abusive

@ Mr. Black – don’t buy any lottery tickets today – you’re on a losing-streak on all fronts.

In my line of work I protect “muppets” from the people whom you seem to admire; with the aim preventing them from ever becoming “muppets” in the first place. IMO, the lawyers who signed-off on these “no-bid/no-fairness-opinion” deals have a lot of explaining to do to their clients.

Posted by MrRFox | Report as abusive

MrRFox, and apparently doing a great job of it.

Posted by Danny_Black | Report as abusive

Danny Black….keep at it…you’re doing great!…it’s usually the stuck pig that squeals!

Posted by NotoriousBOB | Report as abusive

Why are the banks still ripping us off? Simple. Because they can do it and no one says anything.

Posted by neahkahnie | Report as abusive

We are all muppets. We let it happen because we are greedy.

Posted by neahkahnie | Report as abusive

It’s not easy being green with envy of your competitors is it?

Posted by laguardia23 | Report as abusive

It’s not easy being green with envy of your competitors is it?

Posted by laguardia23 | Report as abusive

At the same time, however, there’s a lot of deregulation in the JOBS act which seems aimed primarily at giving banks a greater opportunity to make money, largely at the expense of investors in the primary markets. Mary Schapiro has some strong and important points: the primary markets are rife with information asymmetries, and someone needs to protect the interests of investors, rather than allowing banks to rip them off with legislated impunity.
Why are the banks still ripping us off? Simple. Because they can do it and no one says anything.
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Posted by Very_baaaad_boy | Report as abusive

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Posted by Very_baaaad_boy | Report as abusive