How Do Stricter Capital Requirements For Banks’ Physical Commodities Businesses Affect Goldman Sachs?
The Federal Reserve recently proposed stricter rules for banks that trade in physical commodities in an attempt to “reduce the catastrophic, legal, reputational, and financial risks” presented by these activities on the banks’ overall business model. ((Federal Register Notice, Federal Reserve Press Releases, Sep 23 2016)) While the financial regulator lists several restrictions on all banks over their physical commodities trading activities, the most notable change proposed is additional capital surcharges on these assets. As it stands now, the new rule is particularly stringent towards Goldman Sachs and Morgan Stanley – the two bank holding companies that have more leeway in the commodities industry due to grandfathering rules. These two banks are expected to calculate the size of their risk-weight assets (RWAs) using a risk weight of 1,250% for physical commodities instead of the 100% figure currently used.
The table below highlights the impact of the stricter capital requirement on Goldman Sachs’ common equity tier 1 (CET1) capital ratio.
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The implementation of the capital surcharge will shrink Goldman’s CET1 capital ratio by 150 basis points. In other words, Goldman Sachs will have to raise a little more than $10 billion in such an event to maintain its CET1 ratio at the current level of 11.8%. As the bank has just under $70 billion in CET1 capital now, this represents a ~15% dilution in Goldman’s equity base – hurting overall returns in the future. Under such a scenario, it would appear more prudent for Goldman to shrink its commodities trading business to soften the impact on the capital ratio figure. After all, the bank generated just $572 million in total revenues from its commodities business over the first half of 2016 – just 4% of the total revenue figure of $14.3 billion for the period.
The chart below captures Goldman’s total fixed income, currencies and commodities (FICC) trading portfolio, and you can see how a reduction in these assets affects our estimate for the bank’s share price by making changes here.
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