February 6, 2023 | Last week our friend and fellow Lotosian William Cohan suggested in the FT that Goldman Sachs (GS) ought to combine forces with Bank of New York Mellon (BK), a marriage that strikes us as less than compelling. Cohan correctly identifies the growing problem: Goldman Sachs under the current team led by CEO David Solomon is stuck between being a traditional securities dealer and a commercial bank, and at present does neither well.
The chart below shows funding costs for GS and some high-cost peers from the FFIEC. Notice how quickly funding expense at GS was rising compared with some of the higher-cost banks and Peer Group 1 even before Q4 2022.
Source: FFIEC
Goldman is too big to hide in the treacherous world of global dealmaking but too small to survive as it is. As we have discussed at some length, funding is the Achilles Heel of Goldman Sachs. This judgment is informed not by asset size but rather two factors: 1) the sources of funding and 2) the stability of the business. Says Cohan:
“The perfect merger candidate for Goldman has long been Bank of New York Mellon, which operates in 35 countries around the world and has $1.8tn of assets under management and another whopping $44.3tn of assets under custody or administration.”
Well, no. BK has a pile of assets under management and also a vast pool of global assets in custody for which it is paid slices of pennies to safekeep. But we must say at the outset that BK is an amalgam of utility businesses that more astute organizations have long since shed and abandoned. An apocryphal tale will illustrate the point.
Once upon a time, we were happy retail customers of The Bank of New York. But one night we were sold to JPMorgan (JPM) in a swap of retail assets by BKNY for the clearing and custodian businesses Jamie Dimon discarded. The private bankers and other lovely aspects of the old BNY quickly disappeared in a cloud of continuous cost cutting. Now we have the Chase web site. Dimon got core deposits and the better end of that trade.
Cohan is correct, of course, that the Federal Reserve Board and other prudential regulators would be unlikely to give Goldman Sachs the keys to the US clearing system by allowing them to acquire BK. Along with the Depository Trust and Clearing Corp (DTCC), BK is the center of the US financial system. Indeed, BK is not a great fit for GS or anybody else – other than Uncle Sam.
The equity returns at BK in Q4 2022 were modest (5.7%), growth and alpha are pretty much non-existent, and operational and counterparty risk is infinite. One day, we could see a government-sponsored merger of DTCC and BK simply to cut costs.
If there is one depository in the US that is very definitely too important to fail in a systemic sense, it is BK. But that also means that nobody is going to buy it. For example:
“On November 21, 1985, the Bank of New York (BoNY) suffered a software failure that left it unable to redeliver securities it had received from other institutions as an intermediary,” wrote Huberto M. Ennis and David A. Price of the Richmond Fed. “The result of the failure was that the bank sought and received $22.6 billion in discount window lending from the New York Fed, a record-setting amount.”
In the mid-1980s, BKNY was a rounding error compared with BK today, but te example is important. Just as GS is mostly a $1.5 trillion asset investment bank with a small depository attached, BK is a global clearing, custody and data processing business with a “small” $450 billion asset depository attached. BK is a “bank” in name only and has few profitable loans on its balance sheet. BK has the lowest gross spread on loans and leases in Peer Group 1 at 2.37%, which is half a point below the banks overhead expenses. Fortunately, BK is about assets under management or in custody instead of credit risk.
The cost of funds for BK is slightly above the average for Peer Group 1 and operating proficiency is poor, with an efficiency ratio in the mid-80s vs 59% for JPM. BK’s operating expenses were more than 75% of adjusted operating income, 20 points above the average large US bank.
Nearly 60% of the bank’s operating income comes from fiduciary activities, necessary and vital services that are entirely relevant and completely undifferentiated. BK is the Bayer Aspirin of banking. GS, which survives based upon being the outlier among global investment banks would find the old Wall Street culture of BK toxic, even today.
So how does BK survive given these dreadful operating metrics? Lots of non-interest income. While the average bank in Peer Group 1 earns less than 1% of assets from non-interest services such as trust, BK’s non-interest income is more than 3% of total assets. Do banking assets even matter when discussing BK? No and yes.
The core BK business is really about processing and safekeeping data, yet the ability to act as custodian for financial assets and payment agent is a unique function of a regulated bank. To have a fixed address on the global payments system, you got to be a bank. To perform the fiduciary and payments functions of BK, you need to be a large federally insured depository institution with a master account at a Federal Reserve Bank. At mere $500 billion in assets, BK is arguably far too small.
BK’s loan book was just $70 billion at year end, mostly real estate loans and other odds and ends with horrible pricing. Remember, the gross yield on BK’s loan book is less than the cost of the bank’s SG&A, so fewer loans is better. The rest of the balance sheet is held in securities, which means that BK had a substantial negative mark on its available for sale assets and retained portfolio at year-end. The accumulated other comprehensive income (AOCI) reported to regulators in Q3 was -$6.6 billion.
BK’s Tier 1 capital position is low, below 6% of total assets at year end, but in terms of Basel IV and "risk-weighted capital," the bank appears adequately capitalized. But if we recall the unlimited operational (and counterparty) risk the bank faces, no amount of capital is adequate. Did we mention the $47 billion in intangible assets? How about the 120% double leverage (Equity investment in subsidiaries / Equity capital )?
In terms of the impact of QT on the bank's tangible net worth, we combine the BK disclosed AOCI ($-6 billion) with a conservative 10% negative mark on the bank’s retained loans and securities (-$20 billion) and subtract $20 billion in goodwill and intangibles, BK was book insolvent at year-end. We performed this same analysis for JPM at the end of 2022 (“Is JPMorgan Insolvent”).
BK claims $193 billion in core deposits, including over $100 billion in foreign deposits, but these are wholesale placements that could and would disappear in a matter of days. Should the US Treasury suffer a debt default, for example, we’ll see how many of those foreign deposits at BK, C and JPM will loiter. Foreign deposits are nor insured by the FDIC, of note. And BK has over $150 billion in non-core funding.
Rather than slamming Goldman Sachs together with BK, a business that is ultimately doomed by the advance of technology, we repeat our view that GS would be better advised to consider combining with a more mainstream lender like KeyCorp (KEY), U.S. Bancorp (USB) or even Citigroup (C). The latter has far more “core deposits” than BK. Remember that Bank of New York Mellon does not have a Main Street retail banking business to support the mammoth global custody business.
Frankly, putting BK and GS together would not help either business and might result in a sum of the parts that is lower than the two banks separately. GS is a highly levered, high-risk business that is overly dependent upon non-core funding. BK is a sleepy, low-margin but very high-risk business at the center of the global financial system. That $40 something trillion in custody assets represents much of the dollar equity investments globally.
The clearest way we can say it is that the risk-adjusted return on capital for BK is negative and probably lower than Goldman, which overall is the highest risk large bank in the US. BK should pay David Solomon and GS to take over this problematic basket of low growth, high-risk businesses. The operational risk of BK is simply impossible to quantify or offset. And note in the chart below that the derivative position of BK is 4x the average for Peer Group 1 and is 2/3rds foreign exchange contracts.
Bill Cohan is right about one thing. Would the Fed and other regulators allow the most important bank in the world of custody and clearing to combine with the highest risk player among the top-ten banks? NFW.
A far better fit would be to put Citi together with Goldman Sachs, give the puny Marcus to Citibank NA and eliminate an investment banking and capital markets competitor. The resulting global institution would have sufficient size to operate as a universal bank and could then afford to combine with a larger asset gatherer. Problem solved.
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