Goldman Sachs is pointing to blowout second-quarter trading results as part of its bid to convince the Federal Reserve it has demanded the bank hold too much capital for an economic downturn.
The bank was told to widen its capital buffer last month after a stress test that assumed significant trading losses, but Goldman is arguing its actual performance proved the business was “countercyclical”, according to a person familiar with its position.
A surge in fixed-income and equities trading revenue made Goldman one of the standout performers in the second quarter, helping the bank to match 2019’s profits despite $2.5bn in provisions for loan losses and litigation costs. Fellow trading powerhouse Morgan Stanley was also a beneficiary of the markets boom, increasing its earnings by 78 per cent versus a year earlier.
The performances came as unemployment surged and global economies swung into recession — a scenario that was in some areas more severe than the one modelled in the Fed’s annual stress tests, which predicted big losses for the two banks. The central bank’s own interventions in the market, including asset purchases of unprecedented quantity and breadth, fuelled a market rally.
The stress test assessment led the Fed to set Goldman Sachs the highest capital requirement of any large bank in the US and to tell the bank it must make up a shortfall by October 1. Goldman executives told analysts on their quarterly earnings call this month that they were in “active dialogue” with the Fed, although the bank would meet the increase in capital without shifting strategy.
The person familiar with the conversations with the Fed said Goldman believed its results showed trading to be countercyclical, with revenues rising as volatility rose, versus the Fed’s assessment of $18.4bn in trading and counterparty losses over nine quarters. Goldman’s stress test result also included a worse-than-peers deterioration in non-trading profits during a crash.
The person would not say if the bank was using the Fed’s formal appeals process to advance its case, which would be the only way to change the October 1 requirement.
Goldman and Morgan Stanley get a second shot at influencing the Fed’s modelling in another stress test to be carried out in the autumn, which could affect the Fed’s view on the ability of banks to continue paying dividends.
On its recent earnings call, Morgan Stanley’s chief financial officer, Jon Pruzan, said his bank’s trading business had already been through a “mini stress test” and “obviously we’ve all seen what the trading results have been”.
Most of Morgan Stanley’s conversations with the Fed were about businesses other than trading, it indicated in the earnings call, including issues such as whether pay for its army of wealth advisers is a fixed or variable cost.
The Fed’s most adverse stress test scenario included US unemployment peaking at 10 per cent, economic output falling by 8.5 per cent, a 50 per cent fall in share prices, a level of 70 on the market’s Vix volatility index and sharp falls in real estate prices.
US unemployment hit a postwar peak of 14.7 per cent in May, while gross domestic product is estimated to have fallen at annualised rate of 35 per cent in the second quarter, according to researchers at the Atlanta Fed, and the Vix peaked at almost 83 in March.
Still, some aspects of 2020 have been better than the Fed’s scenario, particularly equity prices, which are largely flat year to date versus the 50 per cent price fall in the Fed’s model, and real estate prices, which have not suffered the sharp price falls the banks were tested against.
Goldman’s argument is weakened by the fact that even senior executives admit the second quarter was an unrepeatable period, with trading earnings boosted by unprecedented support from the Fed itself.
JPMorgan Chase boss Jamie Dimon warned that trading revenues could halve later in the year.
The Fed discusses its methodology with banks on a bilateral basis and as part of annual modelling symposia that include academics and other interested parties. Regulators have historically been reluctant to accept changes to models proposed by banks.
Til Schuermann, co-head of consulting firm Oliver Wyman’s Americas risk and public policy team, said that if market conditions were similar to those in the stress tests “yet yielded rather different outcomes in real life than in the Fed models’ predictions, then it should motivate questions about the effectiveness of those models”.
Mike Mayo, analyst at Wells Fargo, said that it is “the job of regulators to take a conservative lens, and the job of banks to highlight their favourable results . . . I think there’s a case to be made, but I don’t think it rules the day.”