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September 24, 2008

Resistance Is Futile

Charles Calomiris
Henry Kaufman Professor of Financial Institutions
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Goldman Sachs and Morgan Stanley have taken the plunge. They have decided to become “bank holding companies.

In essence, this means they will enter the brave old world of depository banking, with the regulatory apparatus that this entails, and leave behind the “proprietary trading” business models that have made these institutions the envy of the financial world for the past decade.

The nature of their debts will change (from securities and money market instruments such as repos to deposits), and the level of their portfolio risks will fall as they come under the pressure of a far more intrusive regulatory regime. However, their leverage will remain high and may even increase — access to cheap and reliable sources of debt funding, after all, is the main attraction of becoming a depository bank.

The investment banks’ previous resistance largely reflected the regulatory costs and risk “culture” changes that come with regulated depository banking. Virtually all of the franchise value of Goldman and Morgan is human capital. The folks at these firms are the most innovative product developers and skilled risk managers that the world has ever seen.

Depository bank regulation, supervision and examination prizes stability and predictability over innovation, and banks bear a great compliance burden associated not only with their financial condition but also their “processes” related to both prudential regulatory compliance and consumer protection. None of that is conducive to innovation and nimble risk-taking.

Goldman and Morgan’s moves, therefore, could greatly trim their upside potential and reduce the value of their human capital for developing new products and proprietary trading strategies. What about the benefits? First and foremost, they will be able to use reliable, low-cost deposit financing as a substitute for the shrinking collateralized repo market and other high-priced, market-based debt instruments.

Second, they will be able to preserve their client advisory business and perhaps even compete better in underwriting activities. Stand-alone investment banks have lost market share in underwriting to universal banks over the past two decades because underwriting and lending businesses are linked, and non-depository institutions suffer a comparative disadvantage in funding their lending (as shown in a recent academic paper).

In this sense, the capitulation of the stand-alones marks the final stage of the victory of the relationship banking/universal banking model. Those of us who argued in the 1980s that nationwide branching would allow commercial banks to serve as platforms for universal banks with large relationship economies of scope can now say, “We told you so.”

Bank of America, JPMorgan Chase and Citigroup have all weathered the financial storm and are not under threat of failure because their geographic and product diversification has kept them resilient. It has even permitted them to engage in acquisitions and new stock offerings during the worst shock in postwar financial history.

Somehow, Sunday’s announcements did not make me feel like celebrating. It is not progress, in my mind, to move toward a one-size-fits-all financial system comprised solely of behemoth universal depository banks. Just as community banks still play an important role in small business finance (owing to their local knowledge and flat organizational structures), we need nimble, innovative risk-takers like Goldman and Morgan in the system. What will we do without them?

While I may not be celebrating, I’m also not too worried about the lost long-run innovative capacity of American and global finance, for a simple reason: ultimately, people, not institutions, are responsible for innovation. Smart, innovative people can — and will — find homes elsewhere. The financial landscape will shift, giving rise to new franchises and new structures (perhaps even spin-offs from the current investment banks) that combine features of the old franchises that don’t fit comfortably under the Fed’s umbrella. Global competition, as always, will be a reliable driver of financial efficiency.

A version of this column was also published at Forbes.com.

Photo credit: Steve Kelley


by David Mahoney | September 24, 2008 at 12:58 PM

The editorial in the WSJ on Sep 23 by Calomiris and Wallison (Blame Fannie Mae and Congress for the Credit Mess) was fantastic and I agree 100%. I have over 20 years of experience in mortgage related investments (residential and commercial) with 15 of them at a Wall Street firm. I resigned / retired at the end of 2005 in absolute frustration with the state of the markets. I complained of loose lending standards, low yields (everyone was ignoring risk - they thought it wasn't there) and horrific lending structures. My voice was ignored and many thought I was just unable to adjust to the new paradigm in the markets. I stood by my convictions and told all that would listen that this market was headed to a spectacular collapse. While I was correct in my prediction of a spectacular collapse, I couldn't have predicted such damage. In hindsight, it is not surprising. The market will fall as furiously as it went up. Thanks for the insightful article on Fannie and Congress - it filled in some historical context that I had forgotten. David Mahoney

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