Business | Investment
Solid capital has the upper hand
Fed's Morgan-Goldman decision puts focus on well-capitalised commercial banking world.
- By Francesco Guerrera and Henny Sender, Financial Times
- Published: 23:32 September 26, 2008
A month ago - before the market convulsions that precipitated a government intervention to save Goldman Sachs and Morgan Stanley - a top Wall Street banker pinpointed the Achilles heel of the business model of standalone investment banks.
"We wake up every morning worried about how we will fund our balance sheet that day," he said.
After the weekend, the mornings of that senior banker and many other executives at the two remaining large Wall Street broker dealers will become a lot easier.
The Federal Reserve's surprise decision to allow Goldman and Morgan Stanley to turn into "bank holding companies", abiding by the same rules as their main street rivals, is a rescue operation of historic proportions.
Faced with the real threat that Goldman and Morgan Stanley might follow Bear Stearns, Lehman Brothers and Merrill Lynch on the road to extinction, the US authorities took drastic measures.
In one fell swoop, the decision puts an end to a 75-year era dominated by the rise of "monoline" investment banks and redraws the competitive landscape in the global banking industry.
The change has given a boost to commercial banks, once considered the dino-saurs of the financial world compared with their nimbler, flashier rivals on Wall Street.
The lasting message is that, with capital markets in turmoil, well-capitalised institutions have the upper hand.
"The new financial system will be built around the commercial bank model," said Richard Bove, an analyst at Ladenburg Thalmann, in a note to clients last week.
Sensible decision
Still, the Fed's decision should allay the market's fear that Goldman and Morgan Stanley would succumb to the same forces that sank Bear and Leh-man, at least in the short term.
But the price of survival for the two banks, which only a week ago insisted that their model was not broken, could be steep.
Under the Fed rules, the two will have at least two years, and up to five, to fall in line with the rules and capital requirements observed by the likes of Citigroup and JPMorgan Chase.
The main consequence of the new regime would mean a sharp reduction in the level of debt, or leverage, Goldman and Morgan Stanley carry on their balance sheet.
During the heady days that preceded the current crisis, leverage magnified investment bank's earnings by enabling them to reap huge profits with relatively small amounts of capital.
Lower leverage will not only put pressure on the two banks' future earnings but could also limit the scope of activities such as prime brokerage services for hedge fund clients and proprietary trading.
Executives at Goldman and Morgan Stanley downplayed those fears.
They said they had been reducing leverage since the onset of the credit crunch and arguing they would be able to make up for it by working harder in other areas.
People close to Goldman said it had not given up on its pledge to deliver a return on equity - a measure of profitability - of about 20 per cent on average during each business cycle.
Some gains
In their view, the disappearance of two rivals - Lehman and Bear - has made it easier for the remaining banks to win business and increase prices on their services, offsetting the negative effect of lower leverage.
In addition, all banks face strict limits on the use of retail deposits to fund their capital markets business, which reduce the advantage of commercial banks over Morgan Stanley and Goldman Sachs.
Nevertheless, Morgan Stanley and Goldman are certain to now go after retail deposits.
Although both companies denied any appetite for run-of-the-mill branches and chequeing accounts, they are likely to take advantage of their ability to tap this source of long-term, stable funding.
Share this article
More from Investment
More from Business
Popular in Business
-
XPRESS
Way to go this DSF
A fun-filled route to guide you to all the happening dos in town
Business Editor's choice
-
Travel insurance offers peace of holiday mind
The wisest thing to do is to take out travel insurance before you leave.
-
Controlling risk through managed account
Can be simple stand-alone master funds or can grow to include several special purpose vehicles
-
Regional banking in throes of light and darkness
Loan-loss provision growing but lenders withstanding crisis
