In ordinary times, the SEC's fraud case against Goldman Sachs would have been settled before it was even filed. There would have been a consent decree in which Goldman neither admitted nor denied any wrongdoing, paid a fine, and agreed to make more fulsome disclosures in the future. But these are not ordinary times, and the SEC's very public announcement that it's charging Goldman with misrepresentation and fraud in its marketing of a subprime debt product has become one of the biggest stories in the entire Wall Street scandal.
The filing of the Goldman case has crystallized the public support for more vigorous regulation of Wall Street. The Republican effort to oppose financial regulatory reform is now fading into an effort to forge a compromise that will give them some sort of defensible exit strategy. Under any bill that is likely to pass, derivatives trading will become reasonably transparent; a consumer protection agency will be created with a significant degree of independence; some chairs will be rearranged on the organizational deck of the regulatory ship of state; capital requirements and leverage ratios will be adjusted in ways that will be designed to reduce overall risk; and a systemic risk overseer will be created. This is all good stuff, but none of it is really adequate to address the "too big to fail" structure of the financial industry in a fundamental way. And it won't repair the underlying asymmetry of our having "socialized risk" and "privatized gain" for those entities that have an explicit federal guarantee behind them.
The furor around the Goldman case offers an opportunity to consider Wall Street's most profound, and entirely ignored, crisis. Now that we are seeing the inner workings of the products that Goldman is marketing, we must ask whether what Goldman and others investment banks do deserves the huge public subsidies they have received. Do they do anything that has any real social value?
In the traditional model, investment banks are thought to serve two critical functions. First, they are financial intermediaries: They are the conduits for transferring savings to those sectors of the economy that need capital. They fulfill the essential function, the economists tell us, of efficient allocation of capital. That is where their initial public offering and other capital-raising functions come into play. They enable productive companies to access the capital markets so they can grow their businesses. Second, they are supposed to be market makers that provide liquidity and stability in the markets to permit the free flow of capital on an ongoing basis.
The question that must now be asked is: Are investment banks doing that? Are they doing the things that merit public support at all? Or are they just running a casino with products that have no great social utility? The regulators, legislators, and investigators have not focused on the fact that the fundamental business of banking has changed from capital allocation to, essentially, gambling.
It's time to start figuring out whether and how investments banks perform economically useful functions. To do that, we need to know how big banks deploy their capital and how they make their money. So here are a few questions that I believe are structurally more important than the ones that reporters and senators have been asking about Goldman during the past week:
1. What percentage of Goldman's capital is dedicated to proprietary trading, as opposed to capital formation for client companies?
2. What percentage of Goldman's profits derives from proprietary trading, asset management, and prime brokerage activities; and what percentage comes from capital formation for client companies?
3. What percentage of Goldman's profits derives from marketing and trading derivatives, specifically the synthetic CDOs that are at the heart of the SEC investigation?
4. What percentage of Goldman's capital has been invested in U.S. government securities over the last year, essentially taking advantage of an interest arbitrage between Goldman's cost of capital and the rate being paid on Treasury bills?
5. How much income did Goldman derive from bets against products it marketed?
6. How much capital—debt and equity—have Goldman and the other major investment houses raised for their clients over each of the past five years?
7. How much capital have they invested overseas in foreign-based companies—especially through private equity funds?
This is just a starting list. I hope that the Senate, the SEC, and the Fed have other, more precise questions to add. The point is that we need to get a real measure of the social value of investment banking activity and to determine whether they are fulfilling the essential capital formation and liquidity needs of the markets. We taxpayers have given them billions upon billions upon billions based on the theory that they perform economically useful activities. They need to prove that they do.
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