Quasi-partnership model may help big banks mitigate risk

November 21, 2013

By Henry Engler, Compliance Complete

NEW YORK, NOV. 21 (Thomson Reuters Accelus) – The largest institutions on Wall Street could go a long way towards reducing risky behavior if they changed the way top levels of management are incentivized and compensated, and incorporated elements of a partnership model, says a former Goldman Sachs banker.

Taking a page from Goldman’s bygone management structure, Steven Mandis, now a professor at Columbia University, argues that one needs to think creatively of how to replicate the incentives, and ultimately the behavior, that was at work in the partnership model.

“Typically, each (managing director) received a fixed percentage of the overall annual bonus pool and was personally liable for other managing directors’ actions,” writes Mandis in a recent Harvard Business Review blog posting. “At Goldman there was the added restriction that partners could not pull out their capital until after they retired. The organizational regulation created by this structure was key to managing risk, and we should be thinking about ways to bring it back.”

Mandis has penned a book about his time at Goldman Sachs, called, “What Happened to Goldman Sachs?”, and argues that the firm’s culture has been drifting for years, particularly since it switched from a private partnership to public ownership in 1999. During its partnership period, there were incentives that helped focus the bank’s management and employees on their core values and keep in check possible excesses in leverage and behavior that could potentially cost the firm dearly, says Mandis.

Despite sweeping regulatory reform of the industry, including higher capital and leverage ratios, limits on proprietary trading, as well as more aggressive enforcement actions and multi-billion dollar penalties, there is a nagging sense that regulators have missed the boat in terms of re-shaping banking into a less risky industry. This may be particularly the case where financial penalties, which have recently soared to astronomical amounts, are being viewed by bankers as simply the cost of doing business.

Fines as a cost of doing business

In a report published this week by the European Policy Forum, a think tank focused on public policy issues, the group noted that there is a growing challenge in the UK and U.S. that fines may become routine in the eyes of bankers:

“There are indications that in the United States, where financial penalties on financial services businesses are longer established and tend to be larger than those in the United Kingdom fines are seen as a cost of doing business. Large international banks expect that they may be found guilty of breaches of financial services regulatory norms, that the financial costs involved will be factored into the cost of doing business, and that in some cases due to the prevalence of fines and the wide range of financial services businesses caught by them there is no particular moral oblique in being seen to have been fined.”

The study noted that if such an attitude was commonplace among the banking community, then one had to call into question the effectiveness of enforcement actions that included substantial monetary penalties.

“If fines are failing to make any significant impact on firms, their reputations or their revenues, and increasingly becoming a series of monetary round trips to HM Treasury, the system has clearly become an ineffective and worthless means of enforcement,” the study added.

“Fining companies in breach of regulatory requirements and then sending the revenue to HM Treasury no longer carries public credibility. It should be phased out. . .Where senior corporate executives are responsible for regulatory breaches, they rather than the company itself should be subject to financial penalty.”

Recognizing that heavy fines, while useful, are not enough to turn around ethical lapses, regulators as well are citing the need for more substantive cultural reform. In a report last week, William Dudley, President of the New York Federal Reserve Bank, pointed directly at cultural failures and misaligned incentives that still seem to be at work.

“There is evidence of deep-seated cultural and ethical failures at many large financial institutions. Whether this is due to size and complexity, bad incentives or some other issues is difficult to judge, but it is another critical problem that needs to be addressed. Tough enforcement and high penalties will certainly help focus management’s attention on this issue. But I am also hopeful that ending too big to fail and shifting the emphasis to longer-term sustainability will encourage the needed cultural shift necessary to restore public trust in the industry.”

Partnership model for the for the top tier of management

So, if banks are viewing financial penalties as a normal course of business, and enforcement actions continue to target the institution rather than individuals – in large part because it is incredibly difficult to bring a case of criminal wrongdoing in many of the most high profile cases, including JPMorgan’s ‘London Whale’– could the introduction of a quasi-partnership model re-focus the minds of managers and establish greater accountability?

“I am not suggesting the banks return to being private partnerships,” says Columbia’s Mandis. “But they should move away from today’s norm of discretionary annual bonuses for managing directors to, at least for a select group of top employees (at Goldman the elected “partner-managing directors” represent around 1.5-2 percent of total employees), a shared bonus pool with fixed percentages that would pay a large portion of settlements or losses related to misbehavior and have greater restrictions on selling stock. Managing directors would share in the firm’s successes, but also feel it when others incurred losses or when the firm got hit with fines.”

By creating incentives to hold one another accountable, this top tier would pay closer attention to the businesses they are in and better manage risk and behavior. Ultimately, adds Mandis, they would likely get out businesses they didn’t understand, leading to smaller institutions that could be better managed. The whole notion of “too big to fail,” or “too big to manage” would over time self-correct itself if management had a more personal stake in their organizations.

The missing ingredient — “skin in the game”

Whether such a management model would work for another big firm such as JPMorgan or Citigroup is open to question. But some argue that what distinguished the true partnership model from today’s public-ownership structure was “partner capital.” Under a quasi-partnership structure, there is little “skin in the game,” says Charles Geisst, a professor at Manhattan College, and historian of Wall Street’s partnership history.

“I think if you consider the concept that a managing director who is treated for compensation purposes as a good boy, or girl, as it turns out, that may not be enough,” said Geisst. “If the most they are going to gamble with is next year’s compensation, then they might want to take that risk”

“The thing I fear,” he added, “is that they don’t require the partner to actually have skin in the game. What they are requiring is that their compensation is based on prudence.”

Of course a return to the full-fledged partnership model, where each individual had not only a bonus but one’s own capital on the line, is considered by many not to be a workable structure for either Goldman Sachs or, say, Morgan Stanley, much less larger institutions such as JPMorgan. The need for public capital to compete on a global scale had made the traditional partnership much too limited in scope, prompting most Wall Street firms to shed the old model.

As of today, there are only a handful of investment banks that still retain a true partnership structure, such as Brown Brothers Harriman, with total capital of around $660 million according to 2011 filings. But the quasi-partnership model described by Mandis is already in some aspects at work at Goldman Sachs today, says Roy Smith, a professor at NYU’s Stern School of Business.

“I do think the system that (Mandis) suggested is pretty close to what they have at Goldman right now,” said Smith, a former Goldman Sachs partner himself, who cited that under the bank’s current compensation plan, partner-managing directors are paid a bonus amount equal to 1 percent of pre-tax earnings. In addition, should the bank suffer regulatory fines, they are also liable for part of the payment.

Positive impact on shareholder value

In considering moving towards a quasi-partnership structure, large banks such as JPMorgan, Bank of America, or Citigroup might wish to reflect on potential shareholder benefits. By adopting a more accountable management structure at the very top, the outside perception among investors might be that these organizations were now adopting a longer-term strategic view of their businesses, one that would seek to dissuade ventures that were once designed for short-term gain, say observers.

“The more you share directly in the non-discretionary financial performance of the firm, the higher the level of governance and control,” said Malcolm Salter of the Harvard Business School.

In addition, greater accountability and personal liability for regulatory penalties would ensure that management would work harder at avoiding business decisions that increase such risks, instilling the type of behavior would benefit the bottom line and ultimately shareholders.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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