A buzz ran across Wall Street recently when an executive at one of the largest investment banks in the world quit with style. Greg Smith, executive director and head of Goldman Sachs’ equity derivatives business in Europe, the Middle East and Africa, resigned from the firm by writing an opinion piece for The New York Times.
Smith said it was time to leave his lucrative position because the culture of his workplace had become “toxic and destructive.” Personnel were putting their interests and those of the firm before that of the client.
This problem is nothing new. The financial services industry has always been troubled by conflicts of interest. The love of money, which flows generously through financial markets, too often leads generally good people down the wrong path.
Economists define this issue as a principal-agent problem, or simply an agency problem. Problems arise in any market whenever one person, the agent, contracted to act on the behalf of another, the principal, has a conflict of interest. That is, the interests of each are not aligned.
In the financial markets the key conflict is one of timing. Brokers, investment managers and other financial service professionals need to earn a living from what they do. Meanwhile, investors are generally putting their money aside with the expectation it will earn a good return over time.
These conflicting pressures often lead financial professionals to overtrade, or churn their accounts. Smith of Goldman Sachs describes this problem by a question he often heard from others at the firm, “How much money did we make off the client?” The brokers make more money the more the client buys and sells each trading day.
To prevent this from happening, many look first to the government for protection. In the United States and other advanced economies, there are many legal and regulatory requirements that require responsible actions in the interests of investors. However, our justice system can miss a lot and be slow to serve when violations are found.
The financial industry itself tries to align the interests of investors with the professionals that serve them. Certain compensation plans like fee-only advice and annual fee structures sometimes better motivate brokers and investment advisers to work more toward the interest of their clients.
It also helps that the market for financial services is very competitive. Over the longer run a firm that is not performing in the best interest of its customers and shareholders is likely to lose a lot of business or become a candidate for a takeover. Goldman Sachs is feeling that pressure today.
Despite all these potential protections, Smith’s resignation reminds us that it all comes down to a matter of trust. Just as you have to trust your doctor to put your health ahead of any financial interests, you must trust your financial professional.
So consider where you purchase financial services. When sick, it is unlikely you would call a doctor in New York. Rather, you go see your local medical professional.
Do the same for financial services. Get to know a local financial professional. Visit your local bank or investment firm. These folks live in your neighborhood and, like you, care about the community.
Smith quit because he had to. He couldn’t trust the people he worked for. I am glad he did it in a style that reminds us all what’s important in the financial markets.
Crabb is professor of finance and economics at Northwest Nazarene University in Nampa