Relationships and Transactions, Clients and Markets

The Goldman Sachs story, such a headliner only weeks ago, is suddenly yesterday’s news, swept away by news of oil slicks, a trillion-dollar Euro bailout, and a hung jury in the UK.

Too bad, because I think there’s a deep lesson for us to learn. I for one haven’t figured it out. So I really want your help here. Those of you with a talent for economics and social sciences, please log in and comment on the following: I’m still trying to work this one out.

Trading Business is Crowding Out Client Business

Goldman Sachs went public in 1999. Many of us still think of it as an investment bank, involved largely in M&A work, advising companies on strategic decisions, and managing assets.

But in recent years, the company has become dominated by the business of trading. In 2009, 76% of its revenue came from its trading group.  (Not coincidentally, so did its CEO Lloyd Blankfein). Investment banking revenue was only 10.6% of revenue last year, having declined in dollar and percentage terms the last two years.

Goldman Sachs is not mainly an investment bank, and hasn’t been for some time now. It’s mainly a trading organization. Yet it hasn’t come to grips with that fact—nor have the rest of us.

Goldman’s Annual Report proudly lists its 13 Business Principles. The very first of them is: “Our clients’ interest always come first. Our experience shows that if we serve our clients well, our own success will follow.”

A lofty principle indeed. But how well does it apply to a trading business? Let me suggest—not well indeed. Goldman’s answers under oath in front of Congress showed their discomfort with the conflict between their past principles and their current business model. To a great extent, their answers about trading business boiled down to ‘caveat emptor.’ Which, I would argue, is not such a crazy answer at all when it comes to a trading business.

Goldman has gotten a bum rap for being accused of violating its client-focus principles in its trading business. The fact that they can’t articulately defend themselves doesn’t make them any less prescient than the Senators who berated them with equal lack of clarity.

Relationships vs. Transactions

In Sergio Leone’s The Good, the Bad and the Ugly, Eli Wallach’s character Tuco was fond of uttering statements beginning with, “There are two kinds of people in this world, my friend—those who __, and those who ___.”

To borrow Tuco’s construct, there are two kinds of businesses in this world: transactional, market-based trading businesses, and relationship-driven, client-focused businesses. Wall Street trading of CDOs, derivatives and SUV’s are of the former type; investment banking is (used to be, anyway) of the latter.

A friend tells me how he was recruited from college to trade bonds on Wall Street:

"There were 20 of us in the room. The recruiter came in and yelled in a loud voice, “Who here runs on fear and greed?’ Me and my pal timidly raised our hands; the rest were shocked. ‘The rest of you can leave,’ the guy said; ‘I’ve got my boys right here,’ pointing to me and my buddy. And I never looked back."

Most of the massive growth in the share of GDP that the financial sector has claimed in recent years—I think—has come from trading. (Data, anyone?). But it’s not Wall Street alone.

The ‘trading’ model has been the darling of Chicago economists, CNBC commentators, corporate strategists, ideology-driven MBAs and at least one major US political party for several decades now. It has been applied, with varying degrees of success, to running social institutions from prisons to elementary schools to public sector pension funds. Monetize it, put it out for bid, incentivie it, and let the cleansing forces of markets work their magic.

At the same time, we have become much more aware of the importance of ongoing relationships in business. Concepts like loyalty, holistic supply-chain management, CSR and corporate culture are moving us in the opposite direction—humanizing business, or least trying to connect society with business.

The Model of the future: Trading? Or Client-based?

What happens when these two worlds collide?  Think of–a market-driven approach to highly personal relationships. 

As the world becomes more interconnected, these two views of the world come into conflict. In finance—in which innovation has been forgiven if it increases ‘liquidity’—interdependence has come to be a curse. Push on one block in an interlinked trading world, and you get systemic chaos. The liquidity isn’t always worth the stress.

On the other hand, if you’re not careful about client-based industry models, you get corruption, sloppiness and lack of innovation.

I’m trying to figure out the principles that suggest when we need one, and when the other. It’s got me a bit stumped, to be honest.

But here’s what I do know. Market-based, trading-based industry models should never again be confused with free-range, unregulated operators. No doubt there were peddlers of poisonous snake-oil who thought the creation of the FDA was a major step toward socialism. They were wrong, much as the laissez-faire critics of financial reform are wrong now. Their argument is always the same: the public just needs more education. 

No, it doesn’t: it needs fairly regulated casinos, lotteries, markets and trading exchanges. Nothing wrong with caveat emptor as long as the rules for entry to the casino are clear. (Don’t forget: the natural and quick result of an unregulated market is a monopoly.  Pure competition is highy unstable.)

But even more, the pendulum needs to swing. Trust in trading businesses is limited to things like transparency of data and track records. Quantifiable, metricizable trust has got its limits, humanly and economically.  Useful?  You betcha.  Plenty of legitimate business operations need clean markets to hedge plenty of business uncertainties. But that’s still pretty narrow trust.

Trust in relationship businesses is far richer and deeper, because it deals with the people for whom business is supposed to be operated. Here you’re talking about motives, relationships, connections, synergies, collaboration.  Not only more meaningful, but economically far richer than the zero-sum I-win-you-lose nature of trading transactions.

We need more of that kind of trust.