Blame Outdated Bank Regs Not Goldman

The facts of the SEC's civil fraud case against Goldman Sachs will take time to emerge, but one thing is clear: our current legal structures simply don’t fit the type of business that Goldman and kindred firms engage in.

The SEC has sued Goldman Sachs for civil fraud; the company says it’s not liable. The facts of the case are so complicated--and so reliant on “who knew what, when”—that no honest observer should judge until more information comes out. Basically, however, the SEC says that Goldman encouraged one group of clients to invest in a pool tied to high-risk mortgages, let a hedge fund client that was betting on the collapse of the mortgage pick the contents of the same pool, didn’t properly inform the first group of clients, and thereby committed fraud. (See this Associated Press story for more details.)

While the facts of the case will take awhile to emerge, it does seem to make one thing clear: current legal structures simply don’t fit the type of business that Goldman and kindred firms engage in.

For almost two years, Goldman has been structured as a “bank holding company,” and although nearly every financial regulator in the nation touches some part of the company’s operations, the fundamental rules under which it operates its core corporate entity are the same as those that govern consumer-driven lending and depository institutions like BB&T, PNC, and Bank of America.  If Goldman wanted to, it could start running “open a checking account with Goldman” television ads and posting its “low mortgage rates” in the windows of its offices.

The type of deal Goldman structured—legal or not, ethical or not—is almost the exact opposite of the types of transactions that bank holding companies were originally intended to engage in. It involved billions of dollars, was opaque by design, and existed to make money rather than manage it for consumers and business. Bank holding company regulations had nothing to do with it (that’s why a securities regulator is filing the case) and this fact proves that the current regulatory system doesn’t even come close to fitting a firm like Goldman.

The burdensome, regulate-everything-more approach preferred by the Obama administration would probably lead to the breakup of most Goldman and most other large, sophisticated financial firms that don’t figure out how to gain a favored political status. Simply leaving things be, however, could result in a worst-of-all-worlds situation: financial titans won’t really know what rules they have to follow but taxpayers will almost certainly have to bail them out if they fail.

While traditional distinctions between banking, investments, and insurance have outlived their usefulness, the law does need to draw much clearer lines between things that exist for consumers and smaller businesses and those that exist to structure complex financial deals for rich people and big business. Insofar as the government provides an assurance, guarantee or bailout for anyone (and it should do so far less than it does now), it should do so only in sectors where consumers will suffer direct harm if it does not. Firms and products created by and for the “big boys,” should have much more freedom of action but no assurance of government assistance if things go bad.

The SEC’s charges against Goldman Sachs don’t prove that the firm did anything wrong. But they do help make the case for financial services reform.