William D. Cohan's article in Foreign Policy internet magazine discusses why investment banks, which were once partnerships, became public entities; the incentive system of Wall Street that leads to ever greater risk taking; and Goldman's desire to water down regulations on bank reform.
The CFTC has yet to complete the rules governing derivatives and Basel III capital requirements are viewed with skepticism by the banks.
Risky BusinessRead the full article here
By William D. Cohan - Foreign Policy
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The consequence of these public offerings on recent financial history has been nothing short of profound. Goldman, for instance, which had capital of around $45 million in 1970, when DLJ went public, has capital of around $75 billion today. When capital at these firms was limited and scarce, tough choices needed to be made about how and when to use it. Much care was taken to analyze the associated risks of a large trade or underwriting. Partners were prudent with risk-taking.
But with the capital spigot turned on full blast, risk-taking knew no bounds. What's more, Wall Street's partnership culture -- in which partners were paid from firms' pretax profits and were liable for their entire net worth for losses -- was replaced by a bonus culture in which their risk-taking was rewarded with large, multimillion-dollar bonuses while losses were absorbed by public shareholders -- or as we discovered in 2008, by taxpayers, the poor saps. Worse, there has been little or no financial or legal accountability for the Wall Street bankers and traders who brought the Great Recession to the world's doorstep.
Indeed, it is fairly safe to conclude that each and every one of the financial crises that the world has suffered through in the past generation -- from the crash of 1987 and the credit freeze that followed, to the Asian, Russian, and Mexican crises, to the collapse of hedge fund Long-Term Capital Management in 1998, to the puncturing of the Internet bubble in 2000 -- has in one way or another been caused by an incentive system on Wall Street that encouraged bankers and traders to take large risks with other people's money and where the rewards were in the millions of dollars of annual compensation and the penalties were far and few between. There is no getting around this fact. Because this aspect of the finance life remains virtually unchanged in the wake of the collapse of the housing bubble, chances are high that Wall Street will have a heavy hand in causing the next financial crisis, too, notwithstanding the fact that the losses many firms are suffering these days should make them more cautious.
. . . .The vacuum created by the lack of regulatory reform on Wall Street seems to be getting filled by the prevailing sluggishness in global markets. The persistent lack of demand for Wall Street's services -- from trading (at Goldman, for instance, revenue from this business line is down one-third from 2010 through the first six months of this year) to underwriting to providing M&A and investment advice -- is forcing Wall Street's executives to do what they should have done long ago. Risk-taking is being greatly curtailed, underwriting standards are getting more exacting, superfluous employees are being axed, and those who remain are finally going to have to make do with far less of the obscene compensation that they have been accustomed to receiving.
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