Investment banking - Rebooting

Both revered and reviled, Goldman Sachs struggles to stay relevant

JUST outside Stanford University s campus sits the headquarters of Symphony,

one of the myriad tech companies that sprout like weeds in Silicon Valley.

After a lunch break exercising in a nearby park, a dozen fit-looking employees,

still in workout clothes, help themselves from buckets of fruit, energy bars

and the food of the day (Indian), before plopping themselves in front of

monitors in an airy room bathed in natural light. For the sought-after

engineers making up most of the company s 200-strong workforce, this sort of

environment is the norm. Work is supposed to be healthy and relaxed a far cry

from the terrors of a New York bank with its incessant pressure to sell and

complex internal politics, not to mention often unappetising, pricey food.

Across the continent, in a newly opened tower within the World Trade Centre,

Kensho, a three-year-old company, has a similar feel. Like Symphony but a bit

smaller, it is stuffed with talented engineers. In a New York approximation of

the West Coast, it boasts vertical gardens rectangular patches of vegetation

like framed paintings and a pool table.

Symphony is a messaging platform, owned by a consortium of investment firms. It

offers a critical function at present almost monopolised by Bloomberg: the

seamless incorporation of data and communication that makes the terminal the

most important conduit in finance since Wall Street went from thoroughfare to

metaphor. Kensho screens vast amounts of information speeches, earnings,

earthquakes and on and on to help investors find correlations among all these

data that might move prices.

If the two companies succeed a big if their products could become pervasive.

They are tiny entities with vast potential. And they are examples of technology

firms backed and used by Goldman Sachs, a big investment bank, in its efforts

to transform itself, and indeed its industry, at a time when its core business

is being pummelled by technology and regulation.

In 2014 Goldman spun out a messaging technology developed internally as a new

company, Symphony. Kensho was formed with backing from Goldman in 2013. Early

on, the investment bank had a contractual right to be the sole user of its

products among brokers. Goldman continues to be the only outside investor with

voting rights on the company s board, but many other banks have taken stakes in

it and are customers.

It is possible that these two companies will provide little benefit to Goldman.

Cynics are entitled to wonder whether these and similar efforts are merely a

way of putting a modern veneer on an old structure. Tech companies are

fashionable and widely perceived as helpful; banks are unfashionable and seen

as parasitic. The non-cynical take is that Goldman understands that answers to

the challenges it faces will have to come, at least in part, from outside its

mirrored-glass headquarters in downtown Manhattan. It may have many flaws; a

failure to grasp corporate vulnerability is not among them.

Goldman, with its enormous influence, lavish compensation and alumni network in

pivotal political roles looks anything but embattled. But the firm derisively

dubbed a great vampire squid by Rolling Stone magazine is in the process of

seeing its tentacles severed.

Lost prop

Since 2009 revenues have dropped by a quarter; they remain below where they

stood a decade ago (see chart). Even in a good quarter, such as the one just

completed, its return on equity barely exceeds single digits. Principal

transactions , ie, proprietary trading and investments, produced $25bn in

revenues in 2009 and $18bn in 2010 but only $5bn in 2015. The decline is a

result of new rules that limit these activities and regulators threaten more.

Fixed income, commodities and currency (FICC), the once immensely lucrative

niche that nurtured the careers of Goldman s chief executive, Lloyd Blankfein,

and its president, Gary Cohn, has also been hit hard. Revenues reached $22bn in

2009. In the first three quarters of this year they totalled $5.6bn.

Richard Bove, an analyst at Rafferty Capital Markets, concludes Goldman has

just one superb business left among its distinct parts: its traditional niche

of providing advice on important transactions, notably mergers. Goldman remains

the global leader, despite having missed out on a role in the year s biggest

proposed deal AT&T s attempt to take over Time Warner. Even its M&A business is

in some difficulty as exemplified by its big cutbacks in Asia, where

governments in China and elsewhere still favour local institutions. Goldman

also has a good business in wealth-management, which thrives on sophisticated

schmoozing and does not require much capital.

Its other businesses, which collectively still account for about 60% of

revenues, face unrelenting pressure from regulatory and technological change.

None of this is unique to Goldman. A recent survey of 35 global investment

banks by the Boston Consulting Group implied a long-term, industry-wide

contraction: over the past five years, revenues have declined by 20%, return on

equity has slipped from an inadequate 9% to 6%, and almost every business area

has shrunk, with the exception of the advisory work that represents only about

one-tenth of the overall pie.

Regulators want investment banks to reduce risk, and to do so by cutting out

businesses that directly support their own returns as opposed to those of

clients. That means they cannot hold large inventories of securities, must

reduce proprietary trading and must take on ever more capital (diluting

returns). They should, in short, be intermediaries.

But that intermediary role is also under attack. Big fixed-income investors say

they can underwrite many debt offerings directly. Fewer companies want to issue

public shares. New competition has emerged in the shape of more than 300

fintech companies, a broad term for entities using technology to do what

existing banks do with more people and at higher cost.

Monetary stimulus

So far-reaching are these changes that it is surprising bank revenues have not

fallen further. The most common explanation is that repressed interest rates

have stimulated many borrowers to refinance their debt more cheaply. If so the

positive news will be transitory; the pressures will endure.

In deference to these trends, Goldman describes its strengths in terms of

characteristics superior contacts and execution rather than specific franchises

(which may be imperilled). That provides a framework for four intertwined

strategies.

The first involves collaborative efforts or strategic investments that gave

rise to Symphony, Kensho and a number of similar ventures. Orbit , for

example, is a suite of smartphone apps Goldman developed that enable e-mailing,

browsing and file-saving within an environment controlled by an employer (and

thus accessible by a regulator). It was spun off last October to another

publicly traded company, Synchronoss, in exchange for a minority stake. Such

ventures are more valuable if used more broadly than just by Goldman. If it had

retained control, potential customers might be unwilling to allow a competitor

access to sensitive information.

The second prong is automation. Not all that long ago, 600 people worked on a

vast floor trading shares. Traders yelled and phones were slammed (though

perhaps with more decorum at blue-blooded Goldman than elsewhere). Obscured by

the din were 66 distinct actions, many of them amenable to mechanisation. Now,

Goldman has two people who trade equities and another 200 software engineers

who work on systems that, in effect, do the job on their own. Traditional

investment-banking is ripe for change as well. Goldman has mapped each of the

146 steps of an initial public offering in 51 charts that appear in proper

sequence on a five-foot long roll-out. Costly, redundant steps are being cut

or, once again, automated.

The next big change is in the bank s sources of funds and its lending. Goldman

pays just under 5% interest on its long-term debt, the most stable component of

its funding. Its competitors, JPMorgan Chase and Bank of America, pay a

fraction of one per cent on trillions of dollars of government-insured

deposits. It is not feasible for Goldman to open branches. Nor, these days, is

it necessary. In April, it acquired GE s internet bank with $16bn in savings

accounts, on which it pays an average of 1% in annual interest.

On October 13th, as expected, it launched an online lending arm to match, named

Marcus after the firm s founding Goldman. Clients will pay from 6% to 23% a

year for loans of up to $30,000, to be used to repay more expensive credit-card

debt. The clients are those huddled masses previously not affluent enough to

afford a human Goldman account-manager, but now, apparently, an attractive

market for a Goldman machine.

And that leads to the fourth change in how Goldman interacts with clients. Not

long ago, it was almost entirely through phone-calls, e-mails, electronic

orders and presentations delivered in person. Now, a client portal named

Marquee gives access to tools such as Goldman s risk analytics for trading

shares or arranging hedges (named Studio ) or for corporate clients to create

strategies for executing large share buy-backs ( Athena ).

Behind the paywall

Among the largest challenges for this effort at reinvention is how to charge.

The old methods large fees on deals, commissions on trades, extraction of

spreads (often in opaque ways) between the price paid by buyers and that

received by sellers, the use of information gained in transactions for

proprietary trades are somewhat compromised. Clients know too much and can do

too much on their own. New methods are being considered, such as a fee based on

the number of employees at a firm, or number of users, or some form of

subscription-based remuneration.

The change in environment is accompanied by a change in the Goldman kind of

person. One-quarter of its employees now have a background in some facet of

technology, be it a degree in mathematics, engineering, computer science or the

like. That is up from 5% not long ago (a number it believes is still common for

other banks). And the number of internal engineers underestimates the change

since it does not include outside investments, such as Symphony and Kensho.

Perhaps the oddest aspect of this transformation is how little evidence exists

of a payoff. Athena, the firm says, has been used in many share buy-backs.

Another tool named Simon is widely used by customers who want to create

customised structured notes , or debt instruments. Kensho is profitable.

Symphony has many adopters. But it is early days and in many ways these are

just experiments.

Further transformation is still to come and if, as seems probable, it enhances

efficiency, then the Goldman of the future may do as much as it does now with

far fewer people and smaller costs. In the past, Goldman s rise to the pinnacle

of the investment-banking stack was a consequence of besting its rivals. The

challenge now is less from them than from a difficult external economic,

technological and regulatory environment. As for every other bank, change is

not a matter of choice.