The major beneficiaries of investment banking in the past decade have not been the customers of investment banks, or even investment banks themselves, but the investment bankers.
A remarkable feature of the Madoff fraud is the sophistication of its victims. How did so many financially astute people fall for a crude scam and an implausible narrative? Some have acknowledged that they were suspicious of Bernard Madoff’s easy, regular profits. Some thought his returns might have been based on front-running – using the information derived from his brokering business to benefit his asset management clients.
Sophisticated confidence tricksters have used a similar tactic for thousands of years. The fraudster hints at impropriety, but implies that the target will be the beneficiary rather than the victim. The suggestion – I will call it the “Madoff twist” – has two advantages. It provides a possible explanation of the source of promised gains. And it encourages the victims to keep quiet until – perhaps even after – the deception is exposed.
The device is not exclusive to fraudsters. The fundamental cause of the banking crisis is the multiplicity of conflicts of interest within today’s financial conglomerates. The central tension is between retail and investment banking: access to retail customers’ deposits enabled banks to engage in “own-account trading” on a massive scale and then to call on taxpayer support when losses on trading put the deposits in jeopardy.
But there are also many conflicts within investment banking. The typical activities of a modern investment bank include advising corporate customers, securities issuance, marketmaking, asset management and proprietary trading. The interests of the customers of each compete directly with those of the customers of the other. That is why custom and regulation mandated the separation of these activities, which was gradually eroded in the 1970s.
Even after these legal barriers were eliminated, regulation required Chinese walls and if banks had not been required to establish these demarcations their customers would doubtless have insisted on them. No one could tolerate the idea that a banker advising on a proposed acquisition would routinely pass on information about the progress of the deal to his colleagues who were trading securities. But equally, anyone who believed that Chinese walls were fully effective was naive. So why did sophisticated customers tolerate obvious conflicts of interest?
The Madoff twist provides the answer. Each group of customers understood there were conflicts of interest but believed they were being managed for their benefit. Issuers of securities believed that placings were assisted by the scale of the funds under the discretionary management of banks. Investors who placed money believed asset allocation decisions benefited from the bank’s close contact with corporations. And so on.
These things could not be true simultaneously. Either an asset manager makes investment decisions independently of whether his bank is acting for the issuing company, or he doesn’t. If he does, there is no benefit to the corporation from the bank’s placing power: if not, the investor holds securities an independent adviser would not buy. And so with every other potential conflict. Each group of customers believed the conflict gave them an advantage. At least some of them were wrong.
Perhaps all of them were wrong. Jack Grubman, Citigroup’s famed telecommunications analyst, maintained in 1999 that what had once been a conflict between research by analysts and corporate advisory services was now a synergy. For example, investors could benefit from his insight into the mind of Bernie Ebbers, chairman of WorldCom. In the end, investors lost their money, Mr Ebbers went to prison, and Citigroup’s reputation was blighted by the revelation of internal e-mails that showed the limits of its analysis. The only apparent beneficiary was the well-remunerated Mr Grubman himself.
No one should be seduced by the Madoff twist. If someone is engaged in deception, you should start with a strong presumption that the profits of that deception will accrue to the perpetrator. And so it is with conflicts of interest. The major beneficiaries of investment banking in the past decade have not been the customers of investment banks, or even investment banks themselves, but the investment bankers.