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 Last month we read about Goldman Sachs International being charged with fraud by the SEC amid claims that the bank misled investors about risks of their managed securities backed by sub-prime mortgages during the housing crisis. Later on the UK Financial Service Authority (FSA) launched an investigation which co-incided with Goldman’s stellar first-quarter results . Goldman reported a 91% boost in net profits to $3.5bn and tongue in cheek revealed that it had set aside $5.5bn for its staff bonuses and other compensation.
The fraud charge against Goldman Sachs mirrored the latest round of new international banking rules known as Basel III. The objective of this reform package is the improvement of the banking sector’s ability to absorb shocks arising from financial and economic stress and to reduce the risk of a spill over from the financial sector to the real economy. Basel lll plans to improve risk management and governance as well as strengthen banks’ transparency and disclosures. It is designed to upgrade existing Basel II Framework. Besides new rules on Tier 1 capital base, the Basel Committee suggested rules on counterparty credit risk, minimum liquidity standard, leverage ratios as well as rules for reducing procyclicality and promoting countercyclical buffers.
At the moment a Quantitative Impact Study (QIS) is running until the end of April 2010 in order to calculate the quantitative effects of the new regulations. Beyond doubt some banks and other financial institutions criticize the new reforms and the speed of its implementation and hold back their support on the reform to be set in progress. Standard & Poor’s, takes the view that on the one hand the Basel III proposals improve the Basel II Framework and lead to stronger banks, but on the other hand stricter rules are also likely to affect parts of the financial sector in ways that regulators may not have predicted. With Basel III the committee proposed to raise the quality, consistency and transparency of the capital base. Unfortunately, some of the existing Tier 1 capital defined as the core measure of good quality capital that a bank holds as a percentage of its risk-weighted assets will be disqualified under the new rules.
As a reaction to this rule every national banking lobbyist has strong concerns over how high the Basel Committee on Banking Supervision will set capital requirements. They are afraid of being forced to raise more capital and to keep higher levels of reserves. For example the German banks could be badly hit on their funds, risk situation and therefore on their earning capacity. The bank’s reaction could in turn lead to a reduction in the supply of credit to real economy. Further proposals to cover the counterparty credit risk will increase the capital requirements, thereby creating further pressure on the scope for lending. Another concern related to a lesser supply of credit could potentially be a negative impact on GDP growth.
Turning back to the SEC accusation of fraud the Goldman case involves John Paulson from the hedge fund company Paulson & Co, who helped to packages shaky securities into the portfolio, which cost other investors more than $1bn. According to the SEC, Goldman apparently created a bond that would drop in value, so Paulson could supposedly make a lot of money by betting that it would fall, but as yet Paulson has not been charged.
It is not so surprising that Goldman strongly denies wrongdoing, claiming the SEC’s complaint is “unfounded in law and fact” and that they “look forward to cooperating with the FSA.”
Goldman’s Chairman, Lloyd Blankfein, had to defend the banks behaviour to start with, and the allegation by Carl Levin, democratic senator from Michigan, to put their own interest and profits ahead of the interest of their clients, in a Senate hearing last month where investigators dug up new documents allegedly blaming Goldman with five other mortgage transactions beyond the ABACUS (CDO) investment.[10]
It all seems to be rolling down hill and of course the heat was on as manifested by the drop in Goldman-share of 9% on Friday, 30th April. Furthermore a group of 62 delegates of the US House of Representatives sought a penal procedure and called Attorney General Eric Holder to act accordingly.
This is coupled with more pressure as several shareholders filed a succession of derivative lawsuits against different members of the bank in response to the complaint of the SEC. Observers may lament that this is a storm in a tea cup orchestrated by US politicians aimed to tighten the screws on hedge fund and general banking regulation. As always the effect may be counter productive and the question is – will they now over regulate the banking sector?
In a speech in New York on Thursday, 22nd of April, the American President Barack Obama rebuked Wall Street for condoning risky operations leading to the financial crisis. According to him, new tighter regulations ought to be set out in the financial industry. Yes the combination of the Greek and Euro crisis has also seen the Dow Jones lose its momentum and shed heavily its recent gains. “Until this progress is felt not just on Wall Street but Main Street we cannot be satisfied,” he added. Obama’s speech was a thinly veiled attempt to augment the pressure on Congress for legislation imposing tougher rules. Furthermore Obama scolds the financial industry by his speech. “A free market was never meant to be a free license to take whatever you can get, however you can get it. That is what happened too often in the years leading up to the crisis,”.
He continued saying, “Ultimately there is no dividing line between Main Street and Wall Street. We rise or we fall together as one nation,” Is it a co-incidence that Obama’s speech was just six days after the SEC filed civil charges against Goldman Sachs ?. True Obama rejected that the White House was involved in the timing of the SEC case, yet the charges have encouraged Democrats in their criticism of Republicans who are against the administration’s overhaul proposal, even if the rules in the proposal may not have prevented the transactions involved in the Goldman case.
Matt McCormick, Portfolio Manager at Bahl & Gaynor, said: “It appears to me they have the semblance of a bill and it is going to happen and it is just a matter of when. I think most people view Goldman as the catalyst to get financial reform done.” Matt thinks that “He [Obama] wants to keep the momentum going. He wants to essentially carry the ball over the goal line and get the political win. I think it is now about politics, not about economics.”
It is correct to admit that the fraud charge against Goldman Sachs enhanced the willingness of the Republicans to accept the reform. Democratic and Republican lawmakers said they are close to reach an agreement. On Wednesday, 5th May 2010, the Senate made Progress on the financial regulation reform bill. Two amendments aimed at preventing a repetition of the huge taxpayer bailouts of Wall Street were approved. The Senate voted in favour for a plan enabling a new government protocol for seizing and dismantling big financial companies which are in distress. Furthermore, the Senate voted in favour of an amendment determining that it is not equitable to exploit taxpayer funds to bail out troubled companies. As can be expected the bill faces a number of hurdles.
In fact, Republicans too crave a reform but say the Democrats’ bill is a government overreach. According to Senator Judd Gregg, Republican of New Hampshire, would like to avoid another collapse like the one relating to Lehman Brothers in 2008. To conclude, Republicans are mistrustful that to tighten the screws too much will as a result, significantly dampen our capacity to have the most vibrant capital and credit markets in the world. The battle cry for more banking regulation is reverberating over the ramparts …will it materialise in another Sarbanes Oxley overdose?
Anja Kühn
Law & Finance Researcher at PKF Malta
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