Goldman Sachs, Morgan Stanley Bring Out Chainsaws

NEW YORK (TheStreet) -- Pure-play investment banks Goldman Sachs (GS) and Morgan Stanley (MS) will be under pressure to cut compensation, people and bonuses to boost profits as the outlook for their core capital markets and trading businesses remaining weak heading into 2012.

Their flexibility to do so will be tested when the firms report earnings this week; Goldman is scheduled to report on Wednesday, while Morgan Stanley reports on Thursday.

Analysts ratcheted down fourth-quarter estimates for both Goldman Sachs and Morgan Stanley in the last several months, as it became evident that the weakness in capital markets was likely to stay for some time. Yet, the disappointing trading and investment banking performances from JPMorgan Chase (JPM) and Citigroup (C) in the fourth quarter may have lowered the bar even further.

Investors will be paying attention to management plans to reduce workforce, cap bonuses and defer a greater portion of compensation to the future, all steps that Wall Street has taken in the past to juice up profits when revenues disappoint.

But competitive pressures may prevent banks from cutting too close to the bone and it is quite likely that compensation cuts might not be able to fully offset the declines in revenues in 2011, according to analysts.

Meanwhile, it remains to be seen whether further initiatives on the compensation- and headcount- reduction front will be enough to offset the more long-lasting impact of a changing regulatory environment, one that restricts taking proprietary bets with capital and using leverage to boost returns to shareholders.

2011 may have been a forgettable year for the big banks overall, but the headwinds for Goldman Sachs and Morgan Stanley are particularly intense in 2012.

The European crisis remains a major overhang for capital market activity heading into the first quarter, usually a seasonally strong one for investment banks.

Of greater concern is the impact the Volcker rule, expected to be implemented in July, will have on traditional investment banking business models.

The draft of the rules has raised concerns that the high degree of monitoring and compliance will increase the cost of trading. Worse, some fear that the narrow definitions of traditional functions of traders such as market-making might impact liquidity, particularly in fixed-income markets.

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