In a space of just one week, the landscape of the U.S. financial sector has changed quite dramatically. Days after the collapse of Lehman Bothers and the takeover of Merrill Lynch by Bank of America, the two remaining independent investments banks, Morgan Stanley and Goldman Sachs, have sought to convert themselves into bank holding companies. The development is obviously related to the $700 billion rescue package the Bush administration is seeking to rush through the Congress. Many of the investment banks were used to taking bold bets with their own money and utilising enormous amounts of debt to increase their profits with very little regulatory oversight. In normal times, their aggressive style served them well. Their headline-grabbing deals involving share offerings, mergers, and acquisitions won them accolades around the world. After the sub-prime crisis surfaced over a year ago, the viability of the independent investment banking model was called into question, although the loss of investor confidence came only over the past few weeks. Like many leading players in the financial sector, these investment banks had plunged headlong into esoteric mortgage-backed securities whose risks they did not fully comprehend. Unlike commercial banks, they did not have the back-up of potentially life-saving, retail deposits. As bank holding companies, they will resemble the commercial banks in the matter of rules of governance — more disclosures, higher capital reserves, and tighter regulation. In return, they will have access to emergency funds from the Federal Reserve.
There are significant messages for regulators everywhere. In the U.S., commercial banking and investment banking services were segregated under a 1933 Depression-era Glass-Steagall Act. Even after its repeal in 1999, when financial conglomerates were allowed to undertake a range of activities, they retained the walls between commercial banking and investment banking. As recent events demonstrate, that strategy has cushioned their losses from exposure to the sub-prime crisis. For the two big investment banks, regulatory approval for their transformation can only be the starting point. Evidently both will require hefty doses of capital infusion. Recent reports suggest that they are turning to Japanese investors. Goldman Sachs leveraged every $1 of capital into $22 of assets and Morgan Stanley $1 into $30. Clearly such high leveraging, besides being unacceptable to more prudent conventional banking, might continue to cause problems to the transformed entities irrespective of the other, diversified, financial services they might undertake.