Goldman Avoided Talking About Leverage A Lot This Morning

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GS had earnings today and I guess they weren't that good but all anyone ever wants to talk about on earnings calls these days is leverage ratios. That I suppose is a sociologically interesting fact: is banking a business of selling stocks and bonds and loans and whatnot, or is it a business of optimizing yourself around regulation? You can tell what the analysts think, though I suppose that's like a second derivative; they want to add value to whatever was already obvious to the market. The stock price dropped on, like, not selling enough stocks and bonds and whatnot. Or rather: on making too much money from owning stocks and bonds with Goldman's own capital, and too little on doing more obviously Volcker-compliant-y things. So: still sort of a regulatory question I guess.

But, yeah, all the analysts want to talk about is leverage ratios, and you know who does not want to talk about leverage ratios is Harvey Schwartz. Delightfully someone at Reuters counted the number of times he was asked to quantify Goldman's leverage ratio (eight1) and the number of times he did (zero). He said he was "comfortable" with it, which presumably means that GS will be above 5% by 2018 assuming some rates - possibly at, above, or below the current rates - of capital generation and capital return. But they haven't done the math yet.

Which is curious? The idea of the leverage ratio is that it is a simple, backstop, less mathematically complex, less subject to gamesmanship calculation of a bank's capital cushion than is the risk-based capital regime. But that's all relative and plenty of magic lurks in the leverage ratio too: you can't just, like, look at a balance sheet, divide equity by assets, and get yourself a leverage ratio. Here is Goldman's dog-ate-my-homework excuse note about why they haven't done the math, which is kind of an amazing document, not so much for what it says (capital rules are complicated and still in flux etc.) as for its existence.

Why can't Goldman figure out its leverage ratio? The words say "math is hard" but the meaning is "let's not bind ourselves to any math yet." A lot can change and they don't want to give anything away if there's a chance they can get it back. If, like JPMorgan, you put out a page saying what bits of the new leverage rules you approve of (5% ratio, unfunded commitments, future derivatives exposures) and what bits you don't (collateral disallowance, sold CDS at notional), it's harder to argue against the bits you've already baked in.2

Meanwhile Kevin Roose has a post about bank profits complete with an amusing graph; I'll let you click over and see it but let's just abstract it to this:

And, y'know, a lot has happened since 2003? His point is more or less "the big banks' profitability is invariant to increasing regulation";3 as he puts it:

Wall Street's profit model has proven to be incredibly resilient. ... On Goldman Sachs's earnings call this morning, the bank's CFO, Harvey Schwartz, said something crucial to understanding how Wall Street views new rules given to it by regulators. "We evaluate the rule, we give tools to our people, and in that context ... we adjust," he said. In other words, these new rules aren't roadblocks — they're just speed bumps.

If you take my graph too literally you might conclude that bank profits are more or less fixed: that banks have a more or less fixed ability to make money, coupled with a more or less limitless ability to evade restrictions on their moneymaking. But if profits are fixed and regulatory equity requirements vary, then return on equity will vary too, right?4 If you believe that model - or, at least, if you find it an entertaining way to think about the banking business - then it's pointless for analysts to ask bank CFOs about their business. The business - the numerator of ROE - is basically a constant plus a large noise term. The denominator - the regulatory capital requirements and the bank's response to them - is where all the action is. So you might as well ask about that. Over and over again, if necessary.

Goldman Sachs Reports Second Quarter Earnings Per Common Share of $3.70 [GS]
Regulatory Capital Ratios Disclosure [GS]
Goldman Sachs profit doubles on investment gains, lower tax rate [Reuters]
Reminder: Don’t Pay Attention to Wall Street’s Whines About Regulation [DI / Kevin Roose]

1.Eight times, I mean, not eight percent. Wait! He was asked eight times, I mean. Not eight times levered.

2.On the other hand U.S. leverage ratios so far do not seem susceptible to much model optimization - see here, e.g. "the agencies do not believe a banking organization should be permitted to use internal models to measure the exposure amount of derivative contracts for purposes of the supplementary leverage ratio."

3.Here's stock prices if that makes you feel better:

4.Incidentally the belief that all banks have a fixed 10% cost of equity seems to endure:

The bank's return on equity, a measure of how effectively it can wring profit from shareholders' money, was just 10.5 percent in the second quarter, just above the 10 percent returns investors demand for supplying capital to the firm.

Related

Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: