Why Goldman Sachs Is Not a Bank

In these steamy days of July, bank earnings are more interesting than usual, in part because our friends and colleagues in the financial world continue to intone the false mantra that rising interest rates are good for banks. David Solomon, my former colleague at Bear, Stearns & Co. many years ago, took the baton at Goldman Sachs. Break a leg, David.

First off, it is not true that rising rates are always good for banks. Increased interest rates, for example, have not helped Goldman in the past few quarters. “Banks make money on the spread, that’s it. That’s the story,” said our friend Josh Brown on CNBC’s “Fast Money” this week. At the time, Brown was surrounded by a bunch of happy pundits singing the praises of higher short-term interest rates for bank earnings.

Banks make money on widening spreads, not because of a quarter-point move in Fed funds. Spreads, of course, are not really widening as the Federal Open Market Committee (FOMC) pushes up short-term rates.

After moving up about 75 basis points over the past year, noninvestment grade spreads started to fall after the most recent FOMC rate hike in June. Indeed, the 10-year Treasury note has declined about 30 basis points in yield over the past month, reflecting the continued tightness of credit spreads—at least for some issuers.

We estimate the growth rate in total interest income to be steady at 8 percent through the end of 2019, an admittedly generous assumption given the way that the FOMC has capped asset returns via quantitative easing. On the other hand, we limit the annualized rate of increase in funding costs to “only” 65 percent, a rate of change already more than reflected in the rising funding costs of names like First Republic Bank and Bank of the Ozarks.

Most of the largest U.S. banks that reported earnings recently saw interest expenses rise by mid-double digits, even as interest earnings rose by single digits. Goldman Sachs, for example, saw its funding expenses increase 61 percent year-over-year in the second quarter, while interest income rose just 50 percent.

Goldman makes less than 2 percent on earning assets versus almost 4 percent for its asset peers. So to paraphrase the wisdom of Josh Brown, the firm does not make money on interest rates, up or down, but rather earns fees from trading and investment banking. Goldman profits from the spread, both in terms of price and volume.

The gross yield on Goldman’s loan book (5.24 percent) is superior to its larger peers (4.68 percent), but the numbers are so small that they are not really significant in the overall picture. The total return on earning assets for the firm at 1.85 percent is less than half of the 3.94 percent earned by its larger peers.

Why the poor performance? Because Goldman pays up for nondeposit funding compared to its larger peers. Because it has such a small deposit base, Goldman’s total cost of funds is more than twice (2.45 percent) that of its larger bank peers (0.97 percent) as of the end of the first quarter.

Organically growing Goldman into a true commercial bank will take time and a lot of work, a task that Solomon et al. may or may not be able to accomplish. Building a bank starts first and foremost with stable funding in the form of customer deposits, particularly commercial deposits from small and midsize businesses.

With the intensifying competition for bank funding now very visible in the money markets as the FOMC shrinks reserves, don’t hold your breath waiting for Goldman to transform itself into a traditional depository. Such a transfiguration is possible, but not very likely in today’s markets. Thus, the question for Solomon and his colleagues: Do you really want to be a bank? Really?