May 24, 2024

DealBook: As Wall St. Firms Grow, Their Reputations Are Dying

Harry Campbell

Reputation is dead on Wall Street.

This is not to say that financiers and financial institutions still do not commit foolish misdeeds. Rather, so long as the authorities do not find law-breaking, the penalties are few.

The list of examples is long.

Former directors of Lehman Brothers and Bear Stearns still serve on the boards of public companies, and one, Jerry A. Grundhofer, a former director of Lehman, is on the Citigroup board. Traders responsible for disastrous mortgage bets have easily found lucrative jobs in finance.

Or take Daniel H. Mudd, who not long after being ousted as chief executive of Fannie Mae was named chief executive of the Fortress Investment Group. At Fortress, Mr. Mudd has been paid a salary and stock options worth more than $30 million in the last two years. This was despite the failure of Fannie Mae while he was at the helm, an event that wiped out almost all shareholder value and has cost the federal government more than $90 billion.

And Wall Street itself seems to be bearing little pain. Sure, the banks have been flogged in Congress and are subject to the Dodd-Frank Act, but it does not seem that their financial clients are avoiding doing business with them. This includes Goldman Sachs, which has been pilloried for ostensibly taking short positions against its own clients.

Deal Professor
View all posts

It was not always the case.

During the Great Depression, Goldman Sachs was caught up in a scandal involving the Goldman Sachs Trading Corporation. The taint of the scandal drove away business for more than a decade and made the firm extremely focused on reputation.

Today, both people and institutions seem to bear no penalty for their actions. They are rewarded.

Why does reputation no longer matter?

The reason is unfortunate and partly attributable to why we got into the financial crisis. People simply don’t matter as much on Wall Street as they used to. Instead size and technology carry the day.

Today’s Wall Street is not the Wall Street of 1907 when J.P. Morgan single-handedly used his reputation and wallet to stem a running financial panic.

Until the 1980s, as William J. Wilhelm Jr. and Alan D. Morrison document in their excellent book, “Investment Banking: Institutions, Politics, and Law” (Oxford University Press; 2007), Wall Street was made up of traditional partnerships. These were small groups of investment bankers who represented companies in offering and selling securities and occasionally acquisitions. These bankers put their individual reputations on the line, because there were so few of them. Morgan Stanley, for example, had only 31 partners in 1970 and fewer than 1,000 employees.

But this began to change in the 1980s. Trading markets became much more sophisticated, and trading and brokerage became the investment banks’ primary business. This is a technology game. The better the technology, the better the trading and brokerage operation. Individuals became less important.

The growth of more complex capital markets and a global economy also created much larger financial institutions. Morgan Stanley now has more than 62,000 employees. These banks could use their assets and position to compete in the market for finance and trading. Again, individuals were less important as size dominated. A client now trades or does business with a bank based on its positions or ability to make a market or loan. The executive at the bank executing the transaction is unimportant.

These trends have become omnipresent in corporate America generally as it too has exponentially grown. And when these companies failed or otherwise committed a wrongdoing, their size allowed their reputation to be ignored. After all, it wasn’t the executive’s fault that the bad event happened. It was just the economy or other external factors.

No doubt this plays a part in the vibrant market for chief executives who have been terminated. Bob Nardelli, for example, who as chief executive of Home Depot presided over a stagnant stock price but collected more than $200 million in pay and severance, soon found gainful employment at Chrysler, which later went into bankruptcy. He still works for the private equity firm Cerberus Capital Management.

The clubby nature of the executive suite also contributes to reputation’s decline. Directors and officers socialize together, work together and are much more willing to disregard individual failures because, after all, they are friends. Mark Hurd’s quick hiring at Oracle after his firing at Hewlett-Packard is perhaps an example.

This is all exacerbated by a perverse consequence of financial institution bigness. While individuals generally matter less, the enormous size of these companies makes the few people at the top appear to be of outsize importance. Think of Jamie Dimon at JPMorgan Chase. And because they are so important, any failings must be overlooked.

All of this means that reputation is not much of a factor in corporate America.

This creates problems. In the absence of reputation, the government and regulators act as substitutes to ensure appropriate conduct. The government becomes the enforcer through civil and criminal actions for law-breaking. So what you get is more law to cover for lost reputation.

Those who criticize the Dodd-Frank Act for its 2,000-plus pages should realize that this is partly a consequence of the death of reputation on Wall Street.

There not only needs to be more law, but also a will to prosecute. As has been noted by many, financial crisis prosecutions are few.

But there may be no financial prosecutions because there is no law-breaking. It is here where reputation is still needed. Reputation is an important enforcement mechanism. Reputational sanctions ensure people act appropriately and fill the gap between poor or unethical conduct and law-breaking. It ensures that people are penalized for their mistakes and inappropriate behavior. It is the most important of oils that ensures that the capital markets work.

But in the wake of the financial crisis, cynicism rules. Reputation is ignored, and we have a much diminished financial system as a consequence.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

Article source:

Speak Your Mind