6829417439_2b40bb41c8How does Goldman Sachs make money?

Ever wondered how Goldman Sachs gets money to pay exorbitant bonuses to its employees? For example, in 2011, Goldman Sachs paid around £8 billion in pay, bonuses and shares to its employees around the world. Before the 2008 crisis, Blankfein, the CEO of Goldman Sachs (in 2007) was awarded a cool $67,900,000 in bonuses [1]. To put that in perspective, the median household income in America during the same period was around $52,673 (0.077% of what Blankfein earned) [2]. So how exactly does Goldman Sachs make such huge amounts of money in the first place?

Fortunately for us, since Goldman Sachs is a publicly traded company, it is obliged to reveal its statement of earnings to the public. According to its filings, for the year ended 2011 its net revenues stood at $28.81 Billion. Lets break that down into its various components to get a clear picture at how it arrived at that figure.

Introduction
Goldman Sachs describes its business under 4 broad segments which are its 4 “I’s”.

1) Investment Banking
The traditional investment banking activities include stuff such as advising on Mergers & Acquisitions, underwriting of public offerings/private placements (Simply put, valuating the price of a company to determine the share price during an IPO), risk management for firms among other things. It earns a fee/commission on such activities.

2) Institutional Client Services
This segment deals with the market making activities in the stock, bond, commodity and currency markets. So what exactly is market making and how do market makers make money? The answer is simple – One of the major ways how they make money is from the “bid/ask spread”. Whenever you buy a stock on the exchange (say NYSE), you buy it at the price sellers are willing to sell for (i.e. the ask price) and when you sell a stock, you do it at the price buyers are willing to buy at (the bid price).

Ask Price – The price sellers are willing to sell at – always higher than bid price because sellers want to sell at high as possible (Say $10.05)

Bid Price – The price buyers are willing to buy at – always lower than ask price because buyers want to buy as cheap as possible (Say $10.00)

You must have noticed that the ask price is always a little higher than the bid price. Say the bid of XYZ is at $10, the ask of XYZ would be at around $10.05. In other words, imagine you bought and sold XYZ almost instantly, you would lose $0.05. How is that possible? Where did that $0.05 go? It went to the market maker.

The function of the market maker is to provide liquidity (the more liquid the more easy it is to sell/buy a stock on the exchange) and in turn earns a commission (in the form of the bid/ask spread). That is one of the major ways how Goldman Sacs makes a significant portion of its money. It also takes positions in various exotic derivatives (such as credit default swaps, interest rate swaps, currency swaps, futures, options etc.) via proprietary trading.

3) Investing & Lending
It either invests in existing loans (such as corporate bonds etc) or originates loans to finance its clients. Goldman Sachs claims that these loans are typically of longer term in nature. Apart from bonds, some of Goldman Sachs other investments include investing in equities & real estate.

4) Investment Management.
Imagine you are a very rich guy with assets in the millions of dollars and are confused how to invest that money and make it grow more? This is where Goldman Sacs steps in. It basically provides you with services such as how to manage your portfolio, financial counseling among other things. It clients are not just limited to rich individuals (commonly called HNWI’s) but include institutional clients as well.

Segmental contribution to Goldman Sachs net revenue
Now that we have understood the four broad segment under which Goldman Sachs operates, lets look at the proportion of its income each segment generates.

Its quite interesting that most individuals associate Goldman Sachs as a traditional investment bank but if you take a closer look at the annual report, investment banking only contributed to about 15% of its net revenues in 2011. Investment management, one of the other segments described above contributed around 16.2%. The major portion of its income however came from IC services like market making activities and its investing & lending segments both of which combined contributed almost 70% (around 68.7%) of its net revenues.

Conclusion
This may be quite surprising for some to know that most of Goldman Sachs income doesn’t originate from traditional investment banking & investment management activities (both of which combined contributed to less than a third of its net revenue) but rather from proprietary trading on the stock, bond, commodity & currency markets and its lending/investing activities. In short, a large proportion of Goldman Sachs income is generated from activities such as trading stocks, bonds, forex and gold (commodities).

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I go by my online nick Sengukoi. I have various interests of which finance, economics and the markets are some of the ones at the top of the list. Connect with Sengukoi on Google+

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4 Comments

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  3. Excellent post but I was wanting to know if you could write a litte more on this subject? I’d be very thankful if you could elaborate a little bit further. Appreciate it!

    Reply

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