Goldman Sachs, Morgan Stanley: Playing It Safer

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Executives at Morgan Stanley, by contrast, are taking a more conservative tack. People close to the bank, speaking on condition that they not be named, say the barn-burning double-digit returns of past years cannot continue. They say they will reduce their risk profile, leaving hedge funds as the big risk-taking investors in the financial system, as they scale back on proprietary trading. "We will continue to deleverage," says one person close to the outfit. "The ROEs could come down, but we will still be a profitable business with long-term value and good returns."

The Banks' Own Idea

Indeed, Morgan Stanley is planning to use its big retail presence—a national network of brokerage offices—to build up its banking operations. It will look more like a retail bank and is likely to troll around for retail banks to buy, people close to the outfit say.

Officials of both investment banks say that switching to bank holding company structures was their idea, not the Fed's. Both had been mulling independently just such a change since last spring, when they looked for ways to shore up the firms' capital bases as the collapse of Bear Stearns first shook the markets. Bear Stearns developed major liquidity problems that led it to be rescued by JPMorgan Chase. The idea accelerated with the sales in recent days of Merrill Lynch to Bank of America and the bailout of AIG (AIG). Officials at both banks say they have always operated under high levels of scrutiny and will continue to do so.

Goldman and Morgan both will have to operate under far more strict oversight by the Fed, the Treasury Dept., and the Federal Deposit Insurance Corp. As they morph into conventional banking, they will lose some of the flexibility they've cherished. Morgan, for instance, will not be able to keep physical assets, such as oil, which it does now in its commodity trading operations. Morgan, moreover, will now have to answer to another big owner, since it has partnered with Mitsubishi UFJ Financial Group, Japan's $1.1 trillion-deposit banking group, in a deal that gives the Japanese bank some 20% of Morgan and a board seat.

A Giant Pulling Back

Banks, by their regulated nature, are required to operate more conservatively. But the markets lately have been requiring that of both big investment banks anyway, says Richard X. Bove, an analyst at Ladenburg Thalmann. Bove argues that many of the risk-taking activities that were long the bread and butter for both firms have radically shrunk in the last year, as investors and lenders pulled back. "These companies were being forced to deleverage by the marketplace," he says. So he says the shift to a bank holding company structure, in itself, won't force dramatic changes but will merely reflect those already under way.

If the firms had not found a way to become better regulated, Bove adds, Congress probably would have forced them to. Congress, he says, is viewing Wall Street as the source of the subprime mortgage crisis and the current financial upheaval. "No doubt, some pretty draconian regulation is coming down the stream," Bove says. "If they did not become regulated companies, if they had failed to adopt a bank charter, they would have faced a far more draconian standard." In the $700 billion plan to buy distressed mortgages, he adds, the government wants to purchase the assets from regulated companies, and this structure provides that ability.

The performance of the outfits is likely to remain weak, comparatively, regardless of this change. Bove says the major areas of growth—mortgages, credit derivatives, prime brokerage, private equity, and international expansion—are all under pressure and will continue to be so. "The marketplace is driving this change," he says.

Joseph Weber is BusinessWeek's chief of correspondents, based in Chicago.