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CURRENT ACCOUNT
DECEMBER 20, 2011

Goldman's Conundrum For 2012

By FRANCESCO GUERRERA

What is Goldman up to? The question is ubiquitous on Wall Street. 'Tis the season when the titans of finance take stock, and many of them want to know what their most famous and feared rival will do in 2012. This year, Goldman Sachs Group Inc. is expected to earn its smallest annual profit since 1998, as turbulent markets pushed companies and investors to the sidelines of the deal-making arena. And while Goldman is likely to have swung back into the black in the fourth quarter after losing money in the previous three months—only its second quarter in the red since its 1999 listing— that's not enough to end the year on a high note. This year, Goldman Sachs Group Inc. is expected to earn its smallest annual profit since 1998. Francesco Guerrera discusses how the firm might be able to turn itself around. Photo: Reuters. More worrying, a raft of regulations in the U.S. and Europe threatens the heart of Goldman's famed ability to earn giant returns by using the intelligence it collects from companies and markets to take calculated risks with its own money and that of its clients. With its stock down 48% this year through late Monday morning, compared with a drop of just 3.6% for the broader market, investors, analysts and competitors wonder whether Goldman will react with a new strategy, a change in leadership or even a takeover of a rival. Because of its "pure" business model, (it doesn't have large retail or asset-management operations) and market leadership, Goldman is a test case for the future of Wall Street. The financial industry is struggling to determine whether the changes in market conditions, regulations and investor behavior are part of a normal boom-and-bust cycle or the harbinger of a structural shift. So far, Goldman has voted for the former.

high-reward activities like derivatives. "The U. rather than outpacing it year after year. which also are two of Goldman's strong points. Mr. Large U. so will returns." Chief Executive Lloyd Blankfein told investors last month. Blankfein is right in predicting that. Bernstein Research analyst Brad Hintz has concluded that the antiproprietary trading provision in the so-called Volcker rule may hurt Goldman more than most because of its trading prowess and penchant for proprietary trading. As balance sheets and head counts shrink to respond to the rules. or what is known as proprietary trading. MF Global Holdings—has seen to that. for example. sooner or later. banks have already been forced to close profitable businesses such as trading with their own funds. other than the usual Wall Street response to a downturn: costcutting and layoffs. the new regulations may erase some competitive advantages. They soon will have to put up more capital against high-risk. but may effectively narrow the gap between the Street's best traders and peers.S. Volcker and Basel III are a double whammy for some of the highest-margin businesses." wrote analysts at Standard & Poor's last week. Goldman and its peers are squeezed between the rock of mathematics and the hard place of tougher rules. before adding: "I believe the world will come back and it will snap back". Hear that? Nothing to see here. Mr. in turn. But he is wrong—or overly optimistic—in thinking that such a rebound in demand will translate into the same returns for banks as before the 2008 financial crisis. such as fixed income and derivatives trading. and. investors and companies will want more help raising capital. At least not in the short term. banking industry is undergoing its most radical structural change since the Great Depression.S. more recently."We are not convinced that there is a substantial secular [change] to the business. rising no faster than the annual growth in capital-markets activity. will compound the pressure. will erode returns. Hintz said he believes Goldman's trading revenues—a key profit driver—will go from extraordinary to just ordinary. from the Dodd-Frank law in the U. probably forever. For Goldman. to the international Basel III pact on capital buffers." he wrote in a recent note. New regulations. That. The failure of leveraged institutions—Lehman Brothers Holdings Inc. Goldman and . When equity and currency trading went digital in the early 2000s.S. "The spirit of Volcker attempts to limit outsized risk-taking by individual firms. trading securities and buying businesses. The math is simple: The debt that turbocharged banks' profits in the past is gone. Bankers counter that naysayers shouldn't underestimate Wall Street's chameleon-like qualities.

Write to him at: currentaccount@wsj. If profits don't catch up fast with the historical norm. tougher regulations may help existing players by acting as barriers to entry. Goldman also should be able to take advantage of its culture. substituting people with technology. a measure of profitability. Goldman might need all the drastic measures its rivals speculate about: a leadership change. Indeed. But it will still find it tough to earn high-enough returns to entice investors back.com   . will be around 7% this year. Goldman's return on tangible equity. if fixed income and derivatives go the way of stocks and foreign exchange. Technology could again be the savior. compared with an average of 22% since its initial public offering. The resulting explosion in trading volumes more than offset the drop in the profitability of each trade. to steal a march on rivals. —Francesco Guerrera is the editor of the Money & Investing section of The Wall Street Journal. The real question isn't what is Goldman up to. but what is Goldman up against.others adapted quickly. which tends to minimize conflict and maximize profits. and its prized risk-management skills. a takeover of a competitor with assetmanagement or retail operations and a new strategy.