During the second quarter, Goldman Sachs turned 25 years old as a public company. Like anyone at quarter-life, it has a stronger sense of what it wants to be, but isn’t quite there yet.
Two vital parts of Goldman’s strategy under Chief Executive David Solomon remained well on track in the second quarter, which the bank reported on Monday. One is to do more lending to Wall Street clients. The other is to shift assets from the bank’s own balance sheet to funds managed for fee-paying outside investors.
Both are meant to generate steadier revenue, which shareholders typically value more highly than more volatile market-based revenues. It is all part of Goldman’s broader aim to transition its image from Wall Street’s swashbuckling, boom-and-bust investment bank to a more reliable, diversified institution.
In the second quarter, the bank set new records for equities and fixed-income financing revenue, and for asset- and wealth-management fees. It reduced its historical on-balance principal investments by $2.2 billion, bringing them to under $13 billion.
But there is a third component of its strategy that is also critical: shed the capital required to support a business that is higher risk and more balance sheet intensive. Doing so can boost earnings per share through buybacks and lead to higher return on equity, which in turn translates into a higher valuation.
And here is where Goldman hit a stumbling block during the quarter. The bank saw a sizable increase in its capital requirements coming out of the Federal Reserve’s latest annual stress test. Its new minimum requirement is to have core equity capital representing 13.9% of risk-weighted assets, nearly a point higher than its prior 13% requirement.
In theory this number ought to keep going down—as it did in the prior three stress-test cycles—as the bank sheds assets like private loans and equity investments, which can take big markdowns during an economic downturn, and as it transitions to less-volatile fee income.
Speaking to analysts on Monday, Solomon said the stress-test result “does not seem to reflect the strategic evolution of our business,” and that the bank is “engaging with our regulators.” But he added, “obviously we have more work to do given this result.”
For now, Goldman is handling the uptick in capital requirements. The bank still has a roughly 0.9 percentage point higher capital ratio than it will need, even after returning $3.5 billion worth of capital to investors in the form of share repurchases in the second quarter. Goldman also is raising its quarterly dividend.
However, running with a higher requirement still adds some uncertainty to the bank’s ongoing transformation. There remains the wild card of how the Fed’s new capital requirements, the so-called Basel III endgame proposals, will translate for Goldman Sachs. It seems like the latest changes may shake out more favorably for big banks—but of course Washington has a logic all its own.
And then there is the hoped-for rebound on Wall Street after a fallow period for mergers-and-acquisition activity. The firm’s annualized return on equity in the second quarter was 10.9%, below its midteens target, with Goldman noting that M&A activity was still running well below its 10-year average.
An M&A rebound would be welcome news for Goldman’s leading advisory franchise, which also filters through to the rest of its banking and trading businesses. But taking full advantage would likely consume more capital. Having to pass up any activity because the bank is feeling constrained would be a big opportunity cost.
“We try to get the right balance between deploying on behalf of client activity…and following through in our strategic plan to narrow focus and reduce balance sheet exposure,” Chief Financial Officer Denis Coleman told analysts on Monday.
The Goldilocks scenario would be for the sell-down of balance-sheet assets to pick up pace at the same time overall dealmaking boosts the bank’s revenue trajectory. Lower interest rates may help those pieces all fall into place.
Goldman is still on the path toward becoming the best version of itself as a public company. How long that will take remains the big question.
Write to Telis Demos at Telis.Demos@wsj.com