Morgan Stanley CEO James Gorman recently spoke to the Financial Times, regarding the future of his firm and the industry.  Here is text from the interview:

 

His bank and Goldman Sachs are taking different approaches:

 

What was once an industry of five to 10 investment banks is now two and they are radically different in the way they are approaching it.  We are unambiguously business not as usual and have dramatically changed the shape of our firm.

 

Leverage has been forced out of the system and returns are structurally lower as a result:

 

If you bring leverage down by two-thirds on average – from 30 to 10 or 35 to 12 – if you bring it down by two-thirds, you double capital, mathematically your returns if they were 20-30 are 5-10 and that’s sort of where the industry is and basically those returns reflect the per cent of book that they trade at.

 

So if you’re getting a 5 per cent return and your cost of capital’s about 10 per cent, you’re going to trade at about half book. So I think the first question should be not should we get back to 20 per cent – because if you actually claw back the returns in those years for the losses they generated in subsequent years the returns were never 20 per cent.  That’s the big dirty secret out there.  To say to go back to the old days is to say go back to a fabrication.

 

The first test is do you believe an institution can get back to its cost of capital. We’re generating 5 per cent.  Can we get back to 10 per cent?  That’s much more interesting to me than "can we get back to 15 per cent?" or "will we ever get back to the glory days?" - those are completely flawed anyway.

 

If you can trade at book, book is $27 [at Morgan Stanley] and you just got a 50 per cent increase on your stock price [which closed at $17.47 on Thursday].  Normally you would have to do something heroic – our heroism is to achieve our cost of capital. Then once you achieve that you get into the interesting business model – "who was really clever during this whole process?", "who has miscalculated the government intervention they’re going to get?", "Is Smith Barney either the deal of the century or a complete miscalculation on our part?"  On calls to dramatically scale back or get out of fixed income trading:

 

I don’t think it’s an option and I don’t think it’s wise.  You can fire your revenues by firing your people.  Unfortunately the assets didn’t leave.  Now you don’t have the revenues.  You still have the assets so you still have capital. Congratulations, you’ve now taken a business which is earning 5 per cent to negative 10 per cent.  Well done, now what’s your next trick?  We can’t be that weak-kneed.  We‘ve got to have a little conviction.  And my conviction is there are parts of fixed income that we are very good at, that are very attractive and that are suited to the rest of our businesses: they have connectivity with investment banking, with wealth management, with equities; those are predominantly the flow pieces of fixed income.  We actually have some convictions, we still take a lot of risk, we have an $800bn balance sheet.

 

Will Morgan Stanley ultimately be taken over by a larger bank?

 

I think the fact that we did the deal with Mitsubishi effectively means we merged with Mitsubishi already and now it’s just a question of what the equity ownership structure is.  We did two things – becoming a Fed holding company and selling 22 per cent to Mitsubishi.  Either we keep doing what we’re doing or we do more with Mitsubishi.  We’ve become their global investment bank: they don’t need to build one.  We’ve actually created the perfect business model.  I think this is the best position for both.

 

The universal bank model is under pressure:

 

You have the very interesting dilemma that there are a number of large institutions around the world that have run fully integrated retail, commercial, investment banking, and sales and trading businesses facing a post-crisis world where the regulatory and political tolerance for that business mix is diminished.

 

So, it can lead to one of two things.  Either there are specific limitations by country for institutions that are national champions in what they can and can’t do given that they are responsible for the depository system in the country; or there is forced separation, either by separating the funding sources so that it becomes sufficiently unattractive – which is what I think the Vicker’s inquiry was supposed to do – or more aggressively physically breaking up the banks or – more snail-like – limiting the per cent of deposits any institution can hold or the size of the balance sheet or the leverage so that you don’t break up the banks, but you don’t allow them to grow so as the market grows, new institutions evolve and emerge that fill up that space.

 

I think what is going to happen is that the regulators are going to be encouraging and supporting deals where other institutions get to scale. So, even though some are very big now, I don’t think the probable cases get broken up.  I think it’s that they get very limited in what they can grow and limited in their activities.  So, they decide to do things like shed unnecessary businesses.

 

European banks get a put from their governments:

 

At certain European banks, their financial metrics of liquidity, weighted average maturity, their funding, their capital base, their illiquid assets are dramatically worse than ours.  It’s not even close, but they trade at a premium because the marketplace thinks that at the end of the day their government can’t allow them to disappear.

 

If you’re a European finance minister . . . once they get past this crisis and they say, "how do we stop this from happening again?"  Well, a good place would be to start with not having banks that are bigger than the economy like they are in Switzerland.  The second thing would be to require them to be among the most conservative institutions in the world.

 

So, that’s the big uncertainty in the marketplace. There are a lot of players out there.  Ironically for us, splitting up the banks or restricting banks is all good for us.  We should be out there, cheering it along. They’d lose the cheap funding.  They’d lose the stability.  They’d have to spin off these businesses.  They’d have to deliver.  They’d have to shrink their balance sheets.  They suddenly would become just another investment bank.

 

The trading model changes but the Street rolls on:

 

There is electronic trading.  There will be exchange trading.  A lot of the derivatives can be exchange traded. We’re moving to central clearing, which actually helps us because we are perceived as one of the weaker counterparties.  These are changes in the industry, but . . . yes.  We went through the May Day.  We went through the surge in hostile takeovers.  We went through Drexel appearing and disappeared. Salomon Brothers, EF Hutton, Shearson, Lehman, Smith Barney . . . all these firms disappear and the Street just rolls on.  It’s innovative people putting capital to work.

 

We have a global franchise.  We have global licences.  We’re open in Indonesia, Turkey, Colombia . . . other firms can’t just create this stuff. It’s billions and billions of dollars of embedded expense.  So, we’ve got it.  So, now we’ve got the infrastructure, the people, and the brand.  Now it’s about moving and optimising.

 

[FT, 10/4/12]