Debate on the Investment Bank Model or how to avoid moral hazard

The public resignation, via the New York Times Op Ed page, of Greg Smith reverberated through the financial world and his erstwhile firm–Goldman Sachs. His decision sounded an insight at the core of the financial industry: making money for clients vs. making money for the firm.

Opinions raged on both sides of the debate. Many cited the example as another illness found on Wall Street requiring a cure. Others said Smith merely stated the obvious Wall Street symptom–greed. I present here one of the more nuanced opinions from the Epicurean Dealmaker:

But it is important to realize just how much Goldman Sachs—and other investment banks—sold their legacy, franchise, and long-term value down the river by offering shares to the public.¹ Conversion from partnership to publicly-traded investment banks was not a sufficient cause for the recent financial crisis or our ongoing struggle with the proper form and function of the industry, but it certainly was a contributing factor.

In reality, The author of the blog post discusses a topic mentioned everyday in business school: Moral Hazard. The inner workings of the modern investment banks prove opaque and impossible to value. (Some argue even banks fail to understand the risk on their own books because VaR poorly predicts true risk.) Clients, regulators and shareholders have no idea how much risk banks pose. It was so much simpler when investment banks were smaller and partnerships.

Sadly, we have learned nothing from history. Following the crash of 1929, Congress held hearings in regards to the causes of the crash and the resulting Great Depression. The findings were published in the Pecora Commission Report. Using the recommendations, the Congress passed important regulations instituting transparency and limiting the nature of investment banking.

Returning to the present, how do we fix the moral hazard in the investment banking industry? Perhaps it will fix itself. Clients may tire of being called “muppets,” realizing banks fail to provide a value added product, leaving on their own volition. Maybe the government will decide to reinstate the Glass-Steagall Act to remove the conflicting interests of commercial and investment banking.

The question I end on is: How do we return to a time when banks advised clients and took risks limited to their means (partnerships) — not shareholders and society at large?

Discuss.