Ask the top executives at almost any investment bank or universal bank of note in the world to define their own institution in terms of the competition and they’ll likely compare themselves with the same iconic firm. Goldman Sachs remains the investment bank against which the rest of the industry routinely benchmarks itself. It’s hugely galling to all of its rivals that six years after it went public, that firm retains much of the mystique that cloaked it as a private partnership.
That mystique centres on its astonishing earnings power. But Goldman plays a smart game. Off the record, a senior executive at one of the world’s top three banks makes a more honest assessment. When credit was scarce, banks like his tried to cement CEO and CFO relationships by providing loans, which he himself describes as the dumb money. Goldman has sought to cement relationships by co-investing with clients, leading with equity, the smart money.
More troubling to its competitors than Goldman’s capacity to produce huge profits is their sense that it has changed the investment banking model in ways that they cannot see how to adapt to. Is Blackstone, perhaps, a more natural competitor than Merrill or Lehman? The 20-year old firm made its name as a private equity investor but also has a strong advisory business.
Its competitors like to say that Goldman is somehow putting its client franchise at risk, testing the resistance point to perceived conflicts of interest almost like a consumer products company testing a pricing point for its goods. But it’s a mistake to imagine that Goldman is de-emphasizing its advisory business just because it happens to be making so much money from trading and principal investing.
The more competitors decry Goldman’s reliance on trading revenues, and feign horror at its principal investing and prop trading prowess, the more they inadvertently reinforce its brand as the special one in investment banking.
But how will Goldman’s trading prowess stand up through market cycles? Right now, a lot of smart investors are finding themselves trapped into once profitable but now loss-making positions that were a lot easier to get into than out of.
A little history. In 1993 the global investment banking industry celebrated a stellar year on the rebound from the recession that followed the excessive leverage and subsequent loan losses of the 1980s, the LBO binge, wild real estate investing and the savings & loan crisis. Goldman paid big bonuses to its bond traders, who had made out on the low short-term rates and steep curve with which the Fed bailed out a tottering US banking system. So the next year, jealous traders all around the firm put on the same kind of bets. Interest rates rose, those bets failed, retiring Goldman partners sought to yank their capital, the firm was suddenly in big trouble.
Could the same thing happen again? Investors in Goldman stock will expect the firm’s risk management to be infinitely more robust today. No doubt it is and its equity capital certainly provides a vastly greater cushion against sudden losses than it did then. But even those who have been leading the financial markets in new directions might one day soon realize that they had not understood the degree of leverage in the system, the possible correlations, cascade effects and illiquidity risk of which we have had a glimpse since May.
May Euromoney: Goldman takes a beating, but is still the one to beat
