Monday, August 03, 2009

Goldman Sachs under fire

Goldman Sachs has been, at some point at least, a much admired firm. But it has come under heavy fire in recent months, as reputations in banking and investment banking have tumbled following the sub-prime crisis. The firm's stellar second quarter performance has done nothing to diminish the criticism. If anything, talk of record bonuses has infuriated people even more- the talk is that average pay at Goldman this year could touch a million dollars.

I wrote about this phenomenon in my ET column, Goldmine Sachs is an illusion. On the face of it, Goldman's performance looks impressive. It has increased return on equity while reducing its leverage by half and reducing its dependence on proprietary trading. But, then, Goldman today is a bank fully backed by the Fed. Its borrowing costs are surely lower than what they would be if it did not have an implicit central bank guarantee.

In return for the guarantee, the central bank is entitled to lay down capital requirements and other regulations for Goldman. Goldman's tier I ratio of around 13% is way above the Fed's requirement of 6%. But that is only because the regulatory requirements are far too low and are yet to be revised upwards. Capital requirements for banks will rise, even more so for banks with trading operations and for systemically important banks such as Goldman. The key question is what sort of return on equity Goldman can show after higher regulatory requirements kick in.

I argue that abnormal returns on equity such as the one Goldman showed this quarter (23%) arise not just from inadequate capital requirements but also from other market imperfections. There are others who argue that Goldman was close to imploding like Lehman and was saved only by its alumni ensconced in the corridors of power in the US. They cite the bail-out of AIG and the form it took- cash payments to counter-parties of AIG- as proof.

There's been a huge outpouring of venom towards Goldman. The most recent one is in New York magazine. The earlier celebrated diatribe appeared in Rolling Stone magazine.

Meanwhile, FT reports that Goldman's reputation has been tarnished by recent events.
In a survey of 17,000 Americans, Brand Asset Consulting found that Goldman’s stature – as measured by several gauges of brand strength – had suffered in 2008 and 2009.

“Goldman Sachs still has that Gordon Gekko look to it among the general public,” said Anne Rivers, who oversaw the survey, referring to the villain of the 1987 film Wall Street.

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Anonymous said...

A little confused ... you say Goldman has almost double the amount of tier I capital regulatory requirement and yet you argue that it's high ROI is because of inadequate capital requirements. How come other companies who had lesser capital (in percentage) than Goldman not able to generate such high ROI? Note that GS generated such returns throughout 2007 and some part of 2008 even when other companies were taking larger risks. So saying that high ROI is because of companies taking more risk with their capital is not always true.

Also, you base your argument on the fact that Goldman *had* to be infused with cash because of low capital but the company has publicly stated that it never needed the cash. I can provide you links where Goldman has repeatedly stated that it has a massive amount of war chest to tackle liquidity problems. It had successfully got Warren Buffet to invest in it in addition to selling public notes themselves.

Mostly the infusion was seen as a way not to create more market imbalance by infusing cash in a few companies and subsequently marking them as "weak companies".

The high ROI may or may not be an illusion since no one really understands how the firm makes profits. But saying that it does so simply because of lower capital requirements is not true.

Anonymous said...

"It would be sensible for Goldman to pay bonuses to employees only after allowing for the possibility that ordinary commercial banks will soon have to operate with total capital of around 15%"

doesn't make sense at all. Isn't Goldman's ratio already around 13%?

In fact the basic premise of your argument that high ROI in a crisis environment can be generated only because of these reasons -

lack of competition,
excessive risk-taking,
superior access to information and
the ability to influence regulation.

is clearly inadequate. In a crisis environment, the biggest difference is "leadership and management". Of course, one or more of the factors that you outlined helped. But it ultimately was how the GS leadership managed the crisis which enabled it to be in such a strong position.

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