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Wall Street Clients, Wall Street Victims

The uproar over Greg Smith’s parting shot op-ed as he walked from Goldman Sachs is remarkable.  Strongly held opinions will be shared in many cocktail party conversations in Manhattan and the Hamptons this weekend. Some will say that Smith must have an ax to grind over a dead-end posting to the London derivatives desk. Many will complain of his ingratitude for more than a decade of assumed generosity on each bonus day. Most will say that he should have kept his mouth shut about the institutionalized exploitation of trades with firm clients since everyone (meaning everyone who is “important,” not the general public) knew what was going on anyway.

I have heard no one speculate that he may have been lying. What is unsaid by the chattering elite is far more important than what is said.

All of this has an element of a potential new reality show, a sort of Housewives of Wall Street, featuring out-of-work derivatives traders instead of impulsive and obnoxious wives. Not to spoil the fun, but there is actually a serious side to this episode. I am not referring to the possibility that Goldman will sue to retrieve Smith’s stock options or Goldman’s more than $2 billion loss of market cap in the last three days. Those are serious enough, but there is a theme that has far broader implications for the nation.

Goldman, along with its peers, is engaged in a battle royale with the sturdy, but under-resourced champions of financial reform. No expense is being spared as lobbyists swarm members of Congress urging them to balance the budget by reducing the microscopic budget of the derivatives regulator, the CFTC. And, by the way, they all have a few “technical” amendments to the Dodd-Frank law in their briefcases that, in reality, would restore the shadow markets in which their clients are able to put the world at risk so that they can exploit their oligopolistic market power and preserve their one-third share of all corporate profits in the United States.

Target number one is the Volcker Rule. That part of Dodd-Frank prohibits proprietary trading by federally insured banks with access to the Fed window. But it carves out specific business lines that involve service to customers  As Smith’s piece illustrates so graphically, customer service can be perverted to be just as predatory as the proverbial over-amped trader screaming, “rip their faces off” as he stands before an array of computer screens with a phone at each ear. The Federal agencies, to their credit, recognized this when they proposed regulations implementing the Volcker Rule. Among other safeguards, the proposal requires reporting of a constant stream of data designed to measure actual revenues and risks produced from the permitted client service businesses. Client service should have low risk and low reward results. If the numbers indicate otherwise, an alarm will go off prompting an uncomfortable call from the regulators.

Worse yet, the Volcker Rule includes an explicit prohibition of conflicts of interest.

Goldman and the others think that these safeguards are just too burdensome. Perhaps you are less than startled by that development, especially so in light of the Greg Smith disclosures. Limiting business to simply serving customers for a reasonable compensation is not the business model that has evolved in the banking sector during the decades of deregulation. Interviews with individuals who have worked in these client service businesses provide a glimpse into the evolution of this model. Client businesses simply did not generate revenues and bonuses sufficient to satisfy the employees assigned to these, primarily because they were aware of the enormous profits and bonuses thrown off by proprietary trading. They responded by embedding prop trading in the client activity, creating a huge conflict of interest. It turns out that exploiting conflicts of interest in the derivatives and securities markets with billions of dollars of capital at your disposal can be remarkably profitable. The banks have grown to think that this is appropriate behavior, a stark example of corporate cognitive dissonance.

One important thread in this conversation is the “consenting adult” defense. The customers of firms like Goldman tend to be reasonably sophisticated and must have known what the story was. Goldman even touts surveys that show how their customers are pleased with the service they receive. This is no great surprise. There are only a handful of institutions that can provide the service at all. It is not like customers can shop for a fair deal. Besides, there is significant academic analysis concluding that valuation of many of the products pedaled by Greg Smith and his colleagues involve such computational complexity that the “quants” at the banks are unable to understand what the right price is. However, they have a better idea than their customers so typically the banks come out way on top. (Incidentally, this is a perfect environment for a cycle of massive profits and even more massive losses, the latter being the responsibility of the taxpayers.) It is entirely possible that the customers do not know the magnitude of the problem.

This is by no means a simple matter of rich guys and gals ripping of other rich guys and gals, to no net effect on the economy. Recent studies have found that the financial system has become less efficient in performing its most socially valuable function, the intermediation of funds to be invested in productive businesses. This has occurred notwithstanding enormous advances in information technology and quantitative analysis that create huge efficiencies. The pipeline between savings and pension funds and the manufacturing and infrastructure sectors has sprung leaks that have increased substantially. 

Every time a bank takes advantage of a customer, a little more leaks out of the pipe and into the bonus pool.  This is not like a “crime without a victim.”  The victims can be found at the unemployment office.