Visiting Scholar Charles W. Calomiris

Goldman Sachs and Morgan Stanley have taken the plunge. They have decided to become "bank holding companies" (which is really just a way station en route to becoming "financial holding companies" under the provisions of the Gramm-Leach-Bliley Act of 1999).

In essence, that 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 a reliance on securities and money market instruments like repos to a new reliance on deposits), and the level of their portfolio risks will fall as they come under the pressure of a far more intrusive regulatory regime than they are used to. 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).

For years, Goldman Sachs, Morgan Stanley , Lehman Brothers, Merrill Lynch and Bear Stearns resisted becoming financial holding companies, but now they have all succumbed. Bear and Merrill were acquired by JP Morgan and Bank of America, Lehman failed and Goldman and Morgan have decided to build their own depository franchises--starting with small, little-known entities they already possess called Industrial Loan Companies, based in Utah, and soon developing into depository networks whose future shapes are hard to imagine at the moment, probably even for the managements of Goldman and Morgan.

It is noteworthy that even Merrill, which possesses a large retail brokerage franchise valuable for cross-marketing with a retail depository network, only reluctantly gave in under pressure last week. Obviously, the stand-alone investment banks didn't want it to come to this. Why did they resist it for so long, and what does this tell us about the downside of their capitulation for the structure and efficiency of the American financial system going forward?

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. These folk are the most innovative product developers, and the most skilled risk managers, that the world has ever seen.

Depository bank regulation, supervision and examination prizes stability and predictability over innovativeness, 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 have a big cost in trimming their upside potential and reducing 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. This has happened 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). [1]

In this sense, the capitulation of the stand-alones marks the final stage in 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 that we told you so.

Bank of America, JP Morgan Chase and Citibank 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 based entirely on 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 am not 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 are the innovators, not institutions. Smart, innovative people can (and many will) find homes elsewhere. The financial landscape will shift, giving rise to new franchises and new structures (perhaps even spinoffs 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.

Charles W. Calomiris is a visiting scholar at AEI.

Note

[1] Charles W. Calomiris and Thanavut Pornrojnangkool, "Relationship Banking and the Pricing of Financial Services," NBER Working Paper No. 12622, October 2006.