Goldman Sachs Group Inc (NYSE:GS) has been cutting some of it less profitable hedge fund clients loose and increasing fees on others as it reforms its prime brokerage to be profitable under the more stringent regulatory standards that it faces as a systemically important financial institution (SIFI), forcing smaller hedge funds to look for new service providers.

 

“It’s the most dramatic thing to ever happen in the business,” said Robert Sloan of financial analytics firm S3 Partners, report Justin Baier and Juliet Chung for The Wall Street Journal. “It’s a total redefinition of what’s a good customer.”

Goldman Sachs improves leverage ratio, but has more work to do

In the past investment banks like Goldman Sachs Group Inc (NYSE:GS) gave hedge funds lots of flexibility to keep their business, financing their trades, extending them credit lines that the hedge funds didn’t necessarily put to use, and letting the funds hold cash in their brokerage accounts. With the growing emphasis on capital and leverage ratios, these services are harder to justify unless the client is actually generating a fair amount of profit.

The latest round of shedding hedge fund clients, which also included pulling money out of its internal hedge fund, pushed the bank’s leverage ratio from 4.3% to 4.5%, against a 5% minimum that it has to hit by 2018. The remaining half a percentage point must have Goldman Sachs clients wondering what other services might not be profitable enough to justify the use of capital.

Cuts timed to improve Goldman’s balance sheet ahead stress tests

While the leverage ratios and other SIFI requirements were meant to ensure that large banks can make it through another major recession with needing government bailouts, it could have the additional benefit of improving competition. All of the small hedge funds that are being cut loose by Goldman Sachs Group Inc (NYSE:GS) will have to find a new prime brokerage, and those that remain will have to weigh the benefits they get against the new fees. The rush of new business could spur a lot of development among smaller brokerages.

As for the timing of the changes, Baer and Chung point out that large banks have an incentive to get their balance sheets into the best possible shape by the end of the third quarter because those are the numbers that the Federal Reserve will use for the next round of stress tests.

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