Overcoming Pay and Capital Costs: A Must for Retrofit Bank Success

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Meet the new Goldman Sachs. It should resemble its predecessor, with a few notable differences. However, investors must consider how profitable the resurrected Goldman can become.

Goldman reported its third-quarter results on Tuesday, which were affected by additional charges resulting from its withdrawal from consumer lending and the ongoing disposal of certain capital-heavy investments. The bank’s RoE for the quarter stood at a modest 7.1%. However, excluding these one-time expenses, Goldman stated that its RoE would have reached 10%. Additionally, its core businesses, institutional securities and money management, are expected to generate mid-teens RoEs “through the cycle”.

The credibility of this promise will be tested under the new, streamlined Goldman model. One analyst rightly questioned CEO David Solomon about the firm’s increased pay-to-income ratio despite overall revenue growth. The firm aims for an efficiency ratio, including all operating expenses, of 60%, which appears ambitious.

Solomon intriguingly mentioned that Goldman remains an “aspirational” career brand, with each junior analyst having to stand out from hundreds of other applicants. However, he admitted that the labor market for top talent remains tight, suggesting that Goldman will need to fight hard to retain its stars.

This might sound peculiar considering Goldman has eliminated thousands of jobs this year, and several star executives and rainmakers from its core businesses have left for better opportunities.

In the 1990s and 2000s, Goldman’s proprietary trading and investment banking operations regularly achieved RoEs above 30%, aided by modest regulatory capital requirements. However, everything changed after the financial crisis. The trend towards increased regulation is expected to culminate with stricter Basel III rules. Large banks warn that they may need to increase their equity capital by 25%, triggering a fierce opposition campaign.

Goldman’s competitors, including JPMorgan and Bank of America, continue to benefit from their consumer lending businesses dependent on interest rates. Goldman’s hope lies in positioning itself for a rebound in IPOs and merger activity. Shareholders will hope to avoid being squeezed by rising banker compensation and additional regulatory capital requirements when business activity finally picks up again.