Wednesday, December 05, 2007

Does better governance explain Goldman's success?

Goldman Sachs is one firm that has defied the meltdown in the financial sector. It has sub-prime exposures but it hedged these by shorting mortgates, so it has come out of the present turmoil smelling of roses. What explains Goldman's success at a time of widespread risk management failure?

John Plender, writing in FT, contends this is because of superior governance:

Much of it is down to culture. Until recently, Goldman was a partnership, which is one of the best risk-control mechanisms invented. The culture of partnership, which entails a high degree of mutual surveillance in the common interest, still survives in spite of Goldman’s status as a listed company.

......Most importantly, Goldman ascribes as much status, prestige and pay to people engaged in control functions as to those running businesses. It constantly rotates human capital back and forth between risk control and business operations.

...The structure of boards is also relevant. In the US governance model, the chairman and CEO roles tend not to be split, while the boards are dominated by non-executives who too often lack expertise in risk. Over the recent credit cycle, these non-executive directors permitted a huge escalation of risk across the banking system. They also sanctioned pay deals for CEOs, complete with rewards for failure, that encouraged risk escalation.

....In contrast, Mr Blankfein (CEO of Goldman) is accompanied on the board by two other executive directors, together with Stephen Friedman, a former senior partner of the firm. So there is a core group on the board steeped in the disciplines of risk. And Goldman’s managing directors include Gerald Corrigan, a former head of the Federal Reserve Bank of New York, who is regarded as the pre-eminent expert on financial plumbing.

I am not entirely persuaded. The risk management systems and structures that Plender associates with Goldman are to be found at other Wall Street firms as well- and yet they have done badly. I should know: I have worked for a Wall Street firm myself.

Assigning as much importance to control functions as to managing businesses, for instance, is not unique to Goldman although rotation between the two may be. I also doubt that a superior quality of board has to do with better risk management: it's next to impossible for a board to assess and monitor risk at a large investment banking firm.

What, then, is the explanation for Goldman standing out- apart from the luck factor? My guess is that Goldman's business model may have something to do with it. It is more heavily into deriving income by using its own capital than many others and it has the advantage of long experience in these - proprietary trading, hedge funds, private equity, etc. At a time when the global economy has been booming, private equity especially has a huge upside. Merrill's drive into these businesses is relatively recent and this may explain why it has stumbled badly.

Having a unique business model may help at the margin more than better governance. Macquarie Bank is a fabulous success. That is because its business model was unique- I doubt that better governance is the factor.

No comments: