Editor’s note: I’ve asked Arpit Gupta to share his thoughts on how changing the structure of U.S. financial institutions might lead to a more stable financial system.
As Reihan has noted in this space, an increasingly popular critique of the management of financial institutions centers on the shift of investment banks away from partnerships to public corporations.
Aside from Avik Roy and Pascal-Emmanuel Gobry, Eugene White and the Investment Bank insider Epicurean Dealmaker are two other fans of the partnership model. The Epicurean Dealmaker offers a powerful argument for how the seemingly trivial end of partnerships was actually quite destructive to the accumulated tradition and practice of banks:
Which is why, at the end of the day, the conversion of Goldman Sachs and other investment banks from private partnerships owned and run by their employees for the benefit of their employees to publicly-traded corporations beholden to third party shareholders permanently and irrevocably upset the historical balance at the core of my industry. For all of a sudden, a third party was introduced, one whose interests were firmly and irrevocably aligned with the short-term perspective of the more “commercial” (i.e., sales and trading) side of the house. Public shareholders care for nothing but the present value of their holdings. They don’t really care what the share price of Goldman Sachs will be in five or ten years. And, unlike the high-paid bankers whom they employ, shareholders can exit their investment and exposure to the firm at any time. Why should they care about the long-term franchise of Goldman Sachs? Especially if selling that toxic CDO, squeezing that last drop of fees from an underwriting client, or discounting conflicts of interest to weasel your way into two or more sides of an M&A transaction can boost profits—and, presumably, the stock price—in the near term.
And the kicker is that senior management of the firm, now that it is owned by the public, has a fiduciary duty to maximize value for the shareholders. Even executives who might otherwise be inclined to preserve long-term franchise value at the expense of short-term profits will be persuaded to sign onto the short-term game, because it is their legal duty to do so. Introducing public shareholders into the capital mix inevitably tilts the tenuous balance between short-term and long-term orientations critical to a balanced investment bank decisively toward the former. Add to this the structural changes in the global financial markets over the past decade, which presented huge opportunities to exploit structured products, derivatives, and proprietary trading to bank enormous current profits at the expense of increasing numbers of former clients, and you have the institutional incentive structure which led to our current pass.
I find this argument powerful for several reasons. The timing of the shift from partnerships to public status in the early 2000s among Investment Banks lines up well with the broader shift in behavior of Investment Banks towards more risky and dangerous activities prior to the Financial Crisis. Creating a corporate structure in which inside partners monitor their own firms is a much more attractive proposition then trying to get regulators to understand and manage the financial risk of every institution in the economy.
Jeffrey Friedman and Vladimir Klaus offer a powerful critique of this agency theory of the financial crisis; but partnerships have a number of desirable characteristics from a corporate governance point of view. Partners were vested in the company over a ten-year horizon, and were deeply liable for losses the company took — a powerful incentive to monitor the long-run success of the company. As Reihan has explored in the past, public corporations are not necessarily the ideal form of corporate organization.
Reihan raises one critique of the pro-partnership point of view: that the genie is out of the bottle and modern financial institutions require fund raising on scales only achievable only through public offerings.
The FT’s Lex offers an interesting alternative — financial institutions could copy the French corporate structure of SARLs, which are something of a hybrid between the pure partnership and public company models.
Such French companies (American corporate forms like Limited Partnerships (LPs) and Limited Liability Limited Partnerships (LLLPs) are roughly comparable; as are German GmbHs) have general partners, who remain highly invested in the company and are deeply liable in the event of failure. Additionally, they have junior partners who contribute equity but have little say in corporate governance. The model combines tight ownership and monitoring among a small group of insiders with the ability to raise limited amounts of capital from outside investors.
While many domestic real estate companies and professionals (like accountants and doctors) are organized as LPs; partnerships seem generally less common among American corporations relative to European countries (something like two-third of French companies, and many German ones, are organized in a partnership fashion). Perhaps one limitation relates to the strong degree of liability suffered by general partners in traditional LPs. The relatively new structure of LLLPs — CNN is one — is designed to ensure that general partners face large, but not unlimited, liability. If policymakers felt that such legal forms did in fact diminish (if not eliminate) the systemically risky actions of financial institutions; presumably these legal forms could be made more attractive (or even mandated).
The overall debate here centers on the organization of corporate governance and regulation. The predominant model today combines arms-length governance in capital markets — in the form of having companies go public, and limiting the stakes that investors hold — with regulatory oversight. With the ostensible goal of maximizing financial access, this model forces regulators to handle oversight roles that are better handled by corporate owners themselves. Amar Bhide has suggested an alternative model of corporate governance that would involve greater managerial control by invested and interested owners. Such relational models are particularly well suited among financial companies, where the prudential and long-run focused management by insiders is not well replicated by outside regulators. Even if a pure partnership model proves unworkable for Investment Banks, there are a number of other partnership-type models that seem to work well globally.