A new era at Goldman Sachs starts in the shadow of a scandal

No one is more aware of the value of a brand than Goldman Sachs.

The investment bank, founded in 1869, has advised the biggest and best American companies on the value of theirs for the past 150 years.

Yet these are troubled times for its own brand, tarnished by association with a fraud-ridden Malaysian state-run fund, 1MDB, and hurt by the bank's failure to adapt after the global financial crisis.

These issues were echoed in its first-quarter results, released last week. Revenue came in below expectations — 13% lower than for the first quarter of 2018 — largely as a result of lower trading revenue. The share price fell by more than 3% and the earnings call was peppered with analysts asking questions about 1MDB.

The first task for David Solomon, who took over as chief executive in October, is to clean up Goldman's reputation. In 2012 and 2013 it helped 1MDB raise $6.5 billion across three bond offerings, earning $600 million in fees — far above the norm for such work. U.S. and Malaysian authorities have alleged that much of the money raised was stolen in a scheme masterminded by Jho Low, a Malaysian financier. He has denied wrongdoing (and vanished).

Last November, the Department of Justice announced that a former senior partner at Goldman, Tim Leissner, had pleaded guilty to conspiracy to launder money and to violate foreign bribery laws.

And they indicted Low and another former Goldman banker, Roger Ng, who has also denied wrongdoing. Goldman claims that Ng and Leissner, who transferred embezzled funds into his personal bank account, kept the bank in the dark about their actions.

Since November its share price has underperformed an index of other bank stocks by 10.3 percentage points, suggesting that the scandal may have wiped as much as $9.1 billion off its value.

It is against these headwinds that Solomon must convince Goldman's investors that it can reinvent itself. Its peers have already digested the fact that Wall Street's traditional model, in which banks advise on huge corporate deals and make bold trades on their own behalf, has become less profitable.

According to Michael Spellacy of Accenture, 90% of the economic profit made in the capital-markets industry is now earned on the buy side — that is, by those who manage assets or investments — and just 10% from sell-side investment banking activities. A decade ago that split was closer to 50-50. Goldman's slowness in reacting to these structural changes has allowed its competitors to catch up.

And investors are becoming concerned about the way it earns its returns. Volatile profits, like those from trading businesses, mergers and acquisitions, are less valuable than steady fee-based income, for example from wealth management.

In 2016, Solomon's predecessor, Lloyd Blankfein, took the first steps toward a new strategy by launching a consumer bank, Marcus. In 2017, Goldman announced a target of increasing yearly revenue by $5 billion by 2020. But the focus on expanding consumer lending, which offers a relatively low return on investment, did not impress shareholders.

Goldman continues to trade at just 0.9 times its tangible book value, a measure of the money that might be returned to shareholders if it were liquidated. The average ratio of price to tangible book value for a bulge-bracket bank is 1.15.

As far as 1MDB is concerned, the big worry for shareholders is the size and scope of the penalties. A large fine is all but inevitable. It could be based on the $600 million that Goldman earned from the bond issuance — or the $2.7 billion that U.S. authorities said was stolen from the proceeds. That will be multiplied by anything up to four, depending on the degree to which the firm is found culpable.

That Goldman is cooperating with the Department of Justice will bring the multiplier down; if the Justice Department decides the firm's oversight of compliance procedures was inadequate, it will be toward the higher end.

Steven Chubak of Wolfe Research, an equity-research firm, said he thinks the total will be somewhere between $1 billion and $4 billion.

When it comes to the required shift in strategy, however, Goldman's efforts might soon start to bear fruit. Its expansion into consumer businesses is continuing apace. In 2018 it acquired Clarity Money, a personal-finance app.

When Marcus launched it was as a consumer lender; since then it has added deposit-taking. Though it offers market-leading interest rates, deposits are still a cheap source of funding.

In 2012, just 8% of Goldman's funding came from deposits. Last year that share had risen to 19%. If it can keep replacing wholesale funding with deposits at the pace of the past five years, Chubak said, it will have reduced funding costs by $500 million by 2022.

Its new strategy will mean Goldman is competing on less familiar territory.

Consumer deposits and corporate cash management are competitive markets long dominated by JPMorgan Chase and Bank of America. But they are also huge markets. Even a small slice could have a big effect on Goldman's profits.

The U.S. financial-services industry has been slow to adapt to technological change. An old brand with a new direction might be well-placed to disrupt it.