Thursday, March 15, 2012

Agency Problem: Goldman Sachs Edition

Asymmetric incentives usually leads to conflicts of interests in relationships (seen in both the private and the public sectors), which typically is known as the principal-agent or the agency problem

On how this applies in the evaluation of sources of information I recently wrote,

This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem

Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.

To show you a good example, let us examine the business relationship between the broker and the client-investor.

The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.

How do they conflict?

The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.

Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.

How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.

Writing at the New York Times, a recently resigned Goldman Sachs employee scathingly accuses his former employer of the said infraction.

Writes Greg Smith,

TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way. The firm has veered so far from the place I joined right out of college that I can no longer in good conscience say that I identify with what it stands for…

Goldman Sach’s agency problem, from Mr. Smith’s account (bold emphasis mine)

How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.

What are three quick ways to become a leader? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail…

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. It doesn’t matter how smart you are.

I would add that the cultural transformation of the company may have largely been brought about by the amplification in the political role played by Goldman Sachs in shaping US politics.

A company that earns through political rent seeking or has been protected by regulators will largely become indifferent to its consumers. Since they have become substantially less subjected to market discipline, their priorities will run in the direction of influencing policymaking in line with their interests or gaming the system.

Bottom line: interventionism magnifies the agency problems.

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