Over the summer, U.S. regulators announced new rules that would limit the leverage (ratio of debt or assets to equity) that the biggest U.S. banks can use in their business. The reasoning, backed by several respected scholars, is that leverage was a leading cause of the financial crisis. The argument makes intuitive sense, and leverage ratios provide a clear quantitative measure for regulators to monitor, so regulations have followed.
But leverage ratios aren’t the only risk factors that matter. Corporate incentives and culture may be even more important in explaining what changed on Wall Street in recent years, and by placing too much emphasis on quantitative ratios like leverage, we may be missing some other important parts of the problem.
I came to this conclusion after studying the culture of Goldman Sachs, where I previously worked for 12 years, as research for a sociology Ph.D. that has now grown into a book. Before then, I would have guessed that Goldman’s switch to becoming a public company had led it to take more risks, and that this would have been reflected in higher leverage over time. But I found out that this hypothesis was wrong — Goldman had been highly levered in its past as a private partnership, too.
The focus on finding something to blame (e.g. higher leverage) reminded me of the findings of the research into the Space Shuttle Challenger explosion done by one of my Columbia University sociology professors, Diane Vaughan. The loss of Challenger on Jan. 28, 1986 is usually blamed on a scientific design flaw in the O-rings used to seal parts of the spacecraft together. Vaughan, however, located the disaster’s roots in the nature of institutional life. Organizational characteristics — cultures, structures, politics, economic resources, their presence or absence, their allocation — put pressure on individuals to behave in deviant ways to achieve organizational goals. The design engineers kept taking incremental risks that they thought were acceptable and normalized them — until the disaster.
Leverage ratios might be the O-rings of the financial crisis. My research revealed that high leverage is nothing new for Wall Street firms, though the ratios have varied over time. In the early 1970s, for instance, the ratio of assets to equity for most firms was generally below 8-to-1. But in the 1950s, it sometimes exceeded 35-to-1. According to a 1992 study by the Government Accountability Office, the average leverage ratio for the top 13 investment banks was 27-to-1 during 1991 (up from 18-to-1 in 1990). At that 27-to-1 leverage ratio, only a 3.7% drop in asset prices would wipe out the equity of the bank. According to SEC filings, in 1998, the year before it went public, Goldman Sachs was leveraged at nearly 32-to-1, while in 2006 it was leveraged at 22-to-1. Other Wall Street firms have experienced similar leverage increases and decreases.
At Goldman Sachs, one element that was different in the lead up to the financial crisis was not the amount of leverage but the constraints and incentives faced by partners. Before the IPO in 1999, partners of Goldman Sachs owned equity in a private partnership. When elected a partner, one was required to make a cash investment into the firm that was large enough to be material to one’s net worth. Each partner claimed a percentage ownership of the earnings every year, but it was a fixed percentage — limiting the incentives for risk-taking — and the majority of the earnings stayed in the firm. A partner’s annual cash compensation amounted to a small salary and a modest cash return on his or her capital account. A partner was not allowed to withdraw any capital from the firm until retirement, at which time the capital typically amounted to around 75% of one’s net worth. Even then, a retired partner could only withdraw his or her capital over a number of years. Finally, and perhaps most importantly, all partners had personal liability for the exposure of the firm, right down to their homes and cars. The result was an intense focus on risk, including risks related to ethical standards. As a partnership, each partner was financially interconnected with the others. They had to be very careful about their standards of behavior and the people they allowed into the partnership. One bad decision from a partner could cause all of them to face personal financial ruin.
Over time, though, Goldman Sachs grew from a relatively small group of financially interconnected partners to a publicly traded corporation in which compensation took the form of individual, predominantly discretionary performance bonuses plus stock that could be sold before retirement. The fixed percentages, financial interconnectedness, and personal liability are mostly gone. Relating back to Vaughan’s research on Challenger, organizational characteristics put pressure on individual behavior. The definition of acceptable risk and the consequences of the risk-taking changed over time.
This — not the leverage ratio, which was actually lower than it had been for most of the previous decade — was one of the key elements that made the Goldman Sachs of 2006 so different from the firm of the 1990s or 1980s or 1970s. It may be that cracking down on leverage is simply regulators’ crude way of trying to address issues of corporate incentives and culture. But leverage limits may have unintended consequences for capital markets’ competitiveness, innovation, growth, and efficiency. Understanding the potential problems related to culture, incentives, and pressures, and addressing them head-on, would make more sense.