The Boss Takes a Pay Cut But His Goldman Sachs Vision Survives

Goldman Sachs Group Inc. Chief Executive Officer David Solomon always said he was playing the long game. The investments needed to broaden the bank’s revenue base and improve efficiency would mean “tolerating J-curves and staying committed to new initiatives,” he said in 2020 at the first investor day Goldman had held. In plain English, there would be troubling losses before the benefits.

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The bank and its shareholders didn’t have the “patience and fortitude” Solomon wanted for his digital consumer finance project. A filing on Friday showed his compensation was cut by about 30% to $25 million for 2022. Still, the aim of building durable, reliable revenue remains intact.

But why does Goldman need to earn regular asset management fees and interest income? What was wrong with the old model of a risk-taking, dealmaking investment bank?

Ask Goldmanites and their first answer is: To boost the bank’s stock valuation. Investors weren’t buying the old Goldman anymore. Its earnings were hard to model because deal flow and trading revenue are tied to the animal spirits in boardrooms and financial markets. The bank’s portfolio of private investments was impossible to value from outside.

Analyst predictions for Goldman’s profits varied much more widely than for other banks. In late 2018, Stephen Scherr, then Goldman’s chief financial officer, told a financial conference that his “objective and expectation” was to shrink this variability by adding durable revenue streams.

Goldman’s average annual return on equity has been better than Morgan Stanley’s since the financial crisis of 2008, although it has yo-yoed from year to year. But investors have placed a higher valuation on Morgan Stanley’s stolid improvement in profitability, particularly since 2020.

This looks as if the share price is leading the vision rather than the other way round. It’s not a good idea to let investor-relations people run strategy, according to Daniel Davies (no relation), a banks analyst for more than 20 years and now managing director at independent research firm Frontline Analysts. Investors don’t always communicate clearly: If they say they want more stable earnings, they don’t necessarily mean they want Goldman to become a sprawling financial conglomerate. History shows conglomerates are rarely valued highly.

Neither consumer banking nor asset management is that stable or reliable. Consumer banking is hard work, risky when done badly, and returns aren’t even very high. “Asset management is literally a business where the costs are mostly fixed and the revenues are a percentage of market values,” Davies adds.

These are all strong points, but there is another spur to Goldman’s metamorphosis that can’t be ignored. Goldman became a bank during the financial crisis: It converted to a bank holding company to gain access to Federal Reserve funding. That made it subject to more regulation and capital rules that were toughened up after 2008.

The 30%-plus returns on equity Goldman made in 2006 and 2007 aren’t achievable any more. It has roughly double the capital relative to total assets than it did back then, and it isn’t allowed to trade markets with its own money like a leveraged hedge fund.

Steadier, reliable revenue could also make Goldman appear less risky to regulators, which would mean slightly lower capital requirements, according to Mike Mayo, analyst at Wells Fargo & Co., and so marginally better returns. Bank regulations also incentivize deposit gathering: Retail deposits help banks meet rules on stable funding. Deposits are cheaper than other funding and can be used for Goldman’s large derivatives and bond-trading operations. Thus, Marcus, its digital bank, and Goldman’s transaction-banking and cash-management business should eventually help cut costs.

Regulations also incentivize lending versus trading — or at least a mixture because diversification is seen as less risky than having all your eggs in one basket. Goldman’s push to grow its fixed-income and equity-financing businesses is boosting interest income, and it is relatively safe secured lending. Its GreenSky fintech business, which makes point-of-sale loans for home-improvement projects, seems like decent quality lending too, although it’s bound to be cyclical.

However, credit-card lending, which Goldman does in partnership with Apple Inc., is the riskiest lending of all and looks terrible in stress tests. Goldman’s loan loss provisions in 2022 were $2.7 billion, 7.5-times the cost in the year before, primarily due to credit-card debt. Solomon should seriously consider whether this is a business it ought to be in.

Goldman is doing some of the right things in asset management by aiming to stabilize revenue and cut capital requirements. Its own private equity and debt investments have been ridiculously volatile: Sales and valuation gains boosted revenue more than $6.5 billion between 2020 and 2021 and slashed it by $10 billion last year. Winding these down and replacing them with more third-party alternative funds that it will manage and make investments in or alongside should be more stable and require less capital — eventually.

To make traditional asset management more successful it needs scale, which might require acquisitions like its 2021 deal for NN Investment Partners, or like the transformational purchases that Morgan Stanley has done. But these are financially risky, hard to find and can be hugely disruptive internally.

The final reason why durable revenue is important is that regular, unavoidable costs have grown significantly for Goldman and other banks. Compliance and technology expenses are higher and pay isn’t anywhere near as flexible. A majority of Goldman’s near-50,000 employees aren’t bankers on minimal salaries and vast bonuses; they are engineers and other people who are paid consistently. If takeover activity collapses, their salaries are still due.

Perhaps Solomon thought he could push this further too and reduce Goldman’s reliance on costly rainmakers and traders with ever greater automation in markets or computer- and data-driven services in investment banking. Davies thinks that’s a mistake: Goldman’s core is still a people business built on teamwork and long-term employee relationships. If those bankers think they are becoming secondary to the machines and the assets under management, they may jump to a boutique, or private equity, or join a tech startup – as some have done.

Solomon must tread a fine line. Yes, the old days are gone and reliable, repeatable revenue is important. Goldman’s competition has also changed; its rivals are as diverse as JPMorgan Chase & Co., KKR & Co. and Citadel Securities. But it can’t contain these multitudes, nor should it become a universal bank. It should limit its transformation to things that enhance the dealmaking and risk-juggling skills that make Goldman Sachs what it is. Even that will still take time.