GS May Divest Proprietary Trading - Analyst Blog

Goldman Sachs Group Inc. (GS) is planning to spin off some or all of its proprietary trading businesses this month in order to abide by new regulations, according to a report on CNBC yesterday.

The decision to spin off the proprietary trading businesses followed the regulatory reform bill that became law in July 2010. A provision in the law called Volcker Rule, named after Paul A. Volcker, former Federal Reserve chairman, restricts banks from utilizing their money to speculate on trades in order to prevent huge risky bets. Since the enactment of the law, this is the first step taken by New York-based investment bank to adapt its business, mindful the U.S. financial reform package.

Goldman is considering two options before arriving at any decision. The first is to seed a hedge fund staffed by its former proprietary traders with the money of the bank and swap it with third party money with the implementation of the new rule in the coming years. The second option is to shift proprietary trading into the bank's asset management unit, in which clients' money is invested instead of the bank’s own money.

According to the regulatory reform, banks will be restricted from proprietary trading and investing more than 3% of their capital in private equity or hedge fund investments in the long term. Proprietary trading has been a pivotal source of investment bank profits and the step is an attempt to minimize the speculation on banks, which might be the reason of the recent financial crisis.

At present, GS has more than 27% of its capital invested in such entities, followed by Morgan Stanley (MS) at 8.9%; Citigroup Inc. (C) and Bank of America Corporation (BAC) each having 4%. Such portion of investment in such entities will affect the bank’s trading revenues to a greater extent in the coming years.

Apart from Goldman, many other U.S. banks including Citigroup, Bank of America Corporation, JPMorgan Chase & Co. (JPM), Wells Fargo & Company (WFC) and Morgan Stanley are trying to reduce their investments in hedge funds and private equity. Though the regulation will take several years before its effects can be seen, these banks are considering a number of options to comply with it.

In the upcoming quarters, we believe that though continuing pressure on trading revenues will hurt the profitability of GS, a slowdown in loan loss reserves like other large banks will support the bottom line.

Goldman currently retains its Zacks #5 Rank, which translates to a short-term Strong Sell rating. However, considering the fundamentals, we are maintaining a Neutral recommendation on the stock.
 
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