Why Goldman Sachs Is Not a Bank

It is a broker-dealer with a small bank in tow
By Christopher Whalen, The Institutional Risk Analyst
July 29, 2018 Last Updated: July 30, 2018

In these steamy days of July, bank earnings are more interesting than usual, in part because our friends and colleagues in the financial world continue to intone the false mantra that rising interest rates are good for banks. David Solomon, my former colleague at Bear, Stearns & Co. many years ago, took the baton at Goldman Sachs. Break a leg, David.

First off, it is not true that rising rates are always good for banks. Increased interest rates, for example, have not helped Goldman in the past few quarters. “Banks make money on the spread, that’s it. That’s the story,” said our friend Josh Brown on CNBC’s “Fast Money” this week. At the time, Brown was surrounded by a bunch of happy pundits singing the praises of higher short-term interest rates for bank earnings.

Banks make money on widening spreads, not because of a quarter-point move in Fed funds. Spreads, of course, are not really widening as the Federal Open Market Committee (FOMC) pushes up short-term rates.

After moving up about 75 basis points over the past year, noninvestment grade spreads started to fall after the most recent FOMC rate hike in June. Indeed, the 10-year Treasury note has declined about 30 basis points in yield over the past month, reflecting the continued tightness of credit spreads—at least for some issuers.

It also reflects that the commercial banks have been gobbling up Treasury issuance ever since the Fed started tapering in December 2013. Their holdings increase by $750 billion during that period, guaranteeing them a risk-free profit. Alas, it may not be enough.

Rising Costs

Second comes the earnings themselves. Bank results released so far for the 2018 second quarter confirm the accelerating upward trend in bank funding costs.

As we detail in the most recent edition of “The IRA Bank Book,” the rate of increase in funding expense for all U.S. banks should exceed the rate of growth in interest earnings by the second quarter of 2019. This will mean that the net interest margin (NIM) will be shrinking, an eventuality that most market analysts and institutional wealth managers are not prepared to accept, much less reflect in asset allocations.

We estimate the growth rate in total interest income to be steady at 8 percent through the end of 2019, an admittedly generous assumption given the way that the FOMC has capped asset returns via quantitative easing. On the other hand, we limit the annualized rate of increase in funding costs to “only” 65 percent, a rate of change already more than reflected in the rising funding costs of names like First Republic Bank and Bank of the Ozarks.

Most of the largest U.S. banks that reported earnings recently saw interest expenses rise by mid-double digits, even as interest earnings rose by single digits. Goldman Sachs, for example, saw its funding expenses increase 61 percent year-over-year in the second quarter, while interest income rose just 50 percent.

Citigroup, on the other hand, being well-positioned in the world of institutional funding, saw interest expenses rise only 28 percent. But the second-quarter earnings seem to confirm a rising trend in funding costs that could see NIM flatten out and decline by 2019.

No Bank

When Goldman Sachs announced Solomon’s ascension to the top spot, my friend Bill Cohan commented on CNBC that this amounted to a takeover of Goldman by alumni of Bear, Stearns & Co. God does have a sense of humor. He also reminded Andrew Sorkin et al. on CNBC’s “Squawk Box” that the freewheeling Goldman of old is long gone and that it is now run and regulated as “a bank.” Well, no, not really.

Goldman Sachs is basically a broker-dealer with a small bank in tow. Compare the net interest margin of Goldman with its peers. The other members of Peer Group 1, defined by the Federal Financial Institutions Examinations Council (FFIEC), reported NIM of 3.28 percent versus 0.41 percent for Goldman in the first quarter. Because the firm’s bank unit is so small, the overall NIM for the group is 1/10th of its peers compared with total assets.

Goldman makes less than 2 percent on earning assets versus almost 4 percent for its asset peers. So to paraphrase the wisdom of Josh Brown, the firm does not make money on interest rates, up or down, but rather earns fees from trading and investment banking. Goldman profits from the spread, both in terms of price and volume.

The basic problem confronting Solomon and his colleagues is that Goldman really is not a bank. It is regulated like a bank and therefore constrained in terms of business activities, but it does not earn the carry-on assets that most banks take for granted when they turn on the lights each morning. Talk of expanding the banking side of the business (a.k.a. “Marcus”) is fine, but progress in this regard is very slow indeed. Of the $9.4 billion in net revenues reported in the second quarter, just $1 billion represented net interest earnings.

The gross yield on Goldman’s loan book (5.24 percent) is superior to its larger peers (4.68 percent), but the numbers are so small that they are not really significant in the overall picture. The total return on earning assets for the firm at 1.85 percent is less than half of the 3.94 percent earned by its larger peers.

Why the poor performance? Because Goldman pays up for nondeposit funding compared to its larger peers. Because it has such a small deposit base, Goldman’s total cost of funds is more than twice (2.45 percent) that of its larger bank peers (0.97 percent) as of the end of the first quarter.

Organically growing Goldman into a true commercial bank will take time and a lot of work, a task that Solomon et al. may or may not be able to accomplish. Building a bank starts first and foremost with stable funding in the form of customer deposits, particularly commercial deposits from small and midsize businesses.

With the intensifying competition for bank funding now very visible in the money markets as the FOMC shrinks reserves, don’t hold your breath waiting for Goldman to transform itself into a traditional depository. Such a transfiguration is possible, but not very likely in today’s markets. Thus, the question for Solomon and his colleagues: Do you really want to be a bank? Really?

Christopher Whalen is the chairman of Whalen Global Advisors and the author of “Ford Men.” This article was first published by the Institutional Risk Analyst. 

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.