Goldman Sachs ups ante in banking game of thrones

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Goldman Sachs' Chairman and CEO David Solomon attends a session at the 50th World Economic Forum (WEF) annual meeting in Davos, Switzerland, January 21, 2020.

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NEW YORK, Feb 17 (Reuters Breakingviews) - When an industry keeps earning higher returns than it needs, competition should theoretically eat its lunch. Goldman Sachs (GS.N) and its peers prove that doesn’t happen in finance. The Wall Street firm has boosted its medium-term target for return on equity to around 15%, a move presumably meant to narrow a valuation gap with chief rival Morgan Stanley (MS.N) read more . Both are betting that Wall Street’s super-sized profits are here to stay.

Chief Executive David Solomon said on Thursday that Goldman is doing better than he expected two years ago, and not just because of a freakish surge in trading and dealmaking since then. He expects to keep Goldman’s expenses to around 60% of revenue, and also juiced up other important numbers. Its growing consumer bank may make more than $4 billion of revenue in 2024, compared with $1.5 billion last year.

The number Solomon didn’t say out loud is $180 billion – Morgan Stanley’s market capitalization. James Gorman’s firm is around $60 billion bigger than Goldman, because investors value its nearly-identical shareholders’ equity more highly. If Goldman can make profit equivalent to 15% of its book value each year, the same as implied by its rival’s targets, it should have the same valuation.

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In a fair world, sustainable 15% returns on equity would elude both firms. Goldman and Morgan Stanley’s cost of equity is probably around 10%, so anything above that is so-called supernormal profit. But as Solomon pointed out on Thursday, banking, trading and investing are a “scale” business. Big firms thrive, and smaller ones struggle. Those with clout in one market can more easily disrupt adjacent ones, as Goldman’s move into new areas like transaction banking demonstrates.

Nor is it just investment banks that are collecting economic rents. Goldman’s growth plan includes targeting clients that are oligopolists in their own field, such as technology and healthcare firms – America’s most dysfunctional sectors from a competitive perspective read more . It’s also raising by 50% its fundraising target for “alternative investments”, the risky products wealthy investors use to ensure they stay that way.

A good sign that finance has beaten the laws of gravity is Goldman’s profitability target. A 40% margin isn’t just impressive by Wall Street standards – it would be in any sector. The historical average for S&P 500 firms is less than 10%, according to Yardeni Research. Solomon has upped the ante in banking’s game of thrones but only those already in the inner chamber get to play.

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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

CONTEXT NEWS

- Goldman Sachs on Feb. 17 set a target of making a 14-16% return on equity over the next three years, upgrading the 13% goal set two years ago, and reaffirmed its target of keeping expenses to around 60% of revenue.

- Chief Executive David Solomon’s targets also included divisional goals such as generating more than $4 billion in revenue from the Wall Street firm’s consumer bank by 2024, and $750 million from its new transaction banking division.

- Goldman reported a 23% return on equity in 2021, driven by a boost from trading and raising capital for clients that Solomon admitted is unlikely to be sustainable. Its consumer bank, which includes the Marcus retail brand, made $1.5 billion of revenue.

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Editing by Swaha Pattanaik ed Sharon Lam

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