The End of Investment Banks

The End of Investment Banks

On this day in economic and business history ...

Goldman Sachs and Morgan Stanley announced their intent to become bank holding companies on Sept. 21, 2008, in a last-ditch effort to draw on Federal Reserve funds and avoid financial oblivion.

The two venerable investment banks were the last of their kind left standing by this point in the financial crisis. Bear Stearns had foundered six months earlier and had been sold to JPMorgan Chase . Lehman Brothers and Merrill Lynch had both failed a week before the Goldman and Morgan Stanley conversion, but Merrill had also been bought at fire-sale prices. Lehman's collapse had left a sucking vortex in the middle of Manhattan that now threatened to pull in all counterparties. The options seemed bleak: Accept liquidity (tied to stricter regulation), or accept death.

Many financial writers called the move a symbolic end to Glass-Steagall, which had technically been repealed nine years earlier. That legislation had placed a firewall between investment banking and commercial banking -- and had prompted Morgan Stanley's creation in the first place -- but once the two remaining investment banks returned to commercial-banking regulatory regimes, there would be no remaining legacy of Glass-Steagall's firewall against risky big-bank investment bets. Andrew Ross Sorkin and Vikas Bajaj of The New York Times wrote on the impact of this unprecedented move:

It also is a turning point for the high-rolling culture of Wall Street, with its seven-figure bonuses and lavish perks for even midlevel executives. It effectively returns Wall Street to the way it was structured before Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.

By becoming bank holding companies, the firms are agreeing to significantly tighter regulations and much closer supervision by bank examiners from several government agencies rather than only the Securities and Exchange Commission. Now, the firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking.

For decades, firms like Morgan Stanley and Goldman Sachs thrived by taking bold bets with their own money, often using enormous amounts of debt to increase their profits, with little outside oversight.

They were the envy of Wall Street, dominating the industry's most lucrative businesses, landing headline-grabbing deals and advising companies and governments around the world on mergers, stock offerings and restructurings.

But that brash model was torn apart over the last several weeks as investors lost confidence in the way they made those bets during the recent credit boom, when investment banks expanded with aplomb into esoteric securities, the risks of which were not easily understood.

Over several harrowing days, clients started pulling their money, share prices plunged and these banks' entire enterprises were brought to the brink.

Lehman's leverage had done it in, but Goldman and Morgan Stanley teetered on the same ledge. Morgan Stanley's 30-to-1 leverage ratio actually matched Lehman's pre-bankruptcy level, and Goldman's 22-to-1 leverage ratio was not far behind. In the months that followed, the two banks borrowed heavily from the Fed -- Goldman tapped $69 billion in government liquidity by the end of 2008, and Morgan Stanley drew on as much as $107 billion in federal funds in the days after its conversion. Each bank also received $10 billion apiece from federal bailout programs, which has since been repaid.

The deal didn't necessarily help Morgan Stanley rebound from a weak post-dot-com era of tighter IPO regulations, but it appears to have been good for Goldman. Five years after the conversion, Morgan Stanley's net income remains 80% lower than it was when it made the shift, but Goldman's is now more than 250% higher. Both banks have begun to agitate for a return to investment-bank status in response to the proposed Volcker Rule, although they have yet to take that leap.

End of a golden era

It is safe to predict that Monday, September 21, 1931, will become an historic date; the suspension of the gold standard in Great Britain on that day, after the six years of painful effort which followed this country's return to gold in 1925, marks the definite end of an epoch in the world's financial and economic development.

-- The Economist
, "The End of an Epoch," Saturday, Sept. 26, 1931

For years before and after the crash of 1929, Britain's inflexible gold-based monetary policy and overvalued currency (relative to other major economies) stood as roadblocks to recovery after the First World War. The country's fragile economy presented an ongoing risk of gold outflow to stronger nations, and the United States' raging bull market during the 1920s had offered an ideal target for these gold-denominated investments. Once the Roaring '20s ended in America, there was little that Britain could do to adjust its policies or to replenish its coffers without further weakening its economy against others with stronger industrial bases. At the time of its abrogation of the gold standard, Britain held an estimated $36.2 billion in debt, compared to a GDP of roughly $19.4 billion.

Some of the sharpest minds of the financial world hailed the move. J.P. "Jack" Morgan Jr., known for avoiding the press at all costs, broke his long public silence to say that "this step seems to me to be the second necessary stage in the work of the national government, the first being the balancing of the budget." However, some British politicians may have been a little too optimistic. Chancellor of the Exchequer Phillip Snowden proclaimed that "British nationals who are abroad will render community service by returning home and spending their money here." Quickly, citizens! Come spend at once!

Britain's move didn't quite stop the worldwide slide of economies and financial markets, but it did wind up indicating that the crash was closer to its end than its beginning. The country's new expansionary monetary policies also helped rehabilitate a wrecked housing sector. However, leaving gold had a muted impact on Britain's international trade, as other nations followed the move, which Britain itself followed up with a patchwork set of protectionist policies. British economic legend John Maynard Keynes later argued strongly against any return to the gold standard, saying in a British newscast:

It is a wonderful thing for our businessmen and our manufacturers and our unemployed to taste hope again. But they must not allow anyone to put them back in the gold cage, where they have been pining out their hearts all these years.

The United States soldiered on beneath the weight of the gold standard for another year and a half, before President Franklin D. Roosevelt ended that system in the spring of 1933. One final effort was made to sustain an international gold standard following the conclusion of the Second World War, but the America-centric Bretton Woods system eventually proved too much to bear, and the world has effectively operated without a gold standard since President Richard Nixon terminated convertibility in 1971. If history is any guide, any future efforts to return to a gold standard will last no longer than a generation before falling apart.

A new age of banking begins
Bank of America unveiled the world's first large-scale electronic bank bookkeeping system, known as ERMA -- the Electronic Recording Machine, Accounting -- on Sept. 21, 1955. The system, built by the Stanford Research Institute, was designed to streamline check accounting -- an important task, as Bank of America was at this point the world's leading commercial bank in terms of check usage, and check usage was exploding.

Eight billion checks were written in the United States every year by 1952, up from 4 million a decade earlier, and bankers began anticipating that their customers would write 1 billion more checks each year from the mid-'50s onward. Checks had to clear through multiple banks to be completely processed, and about 69 million checks were in process in the American banking system each day by 1955. This volume placed extreme hiring pressure on banks, which typically employed as bookkeepers younger female workers who would either leave after marriage or simply burn out because of the drudgery. Many banks had to replace their entire bookkeeping staffs every year.

Enter ERMA, a pioneering digital solution dubbed "the greatest advance in bookkeeping in the history of banking" by Bank of America President S. Clark Beise. One system could handle the bookkeeping for 50,000 accounts, but since the system weighed 25 tons and contained roughly 190 miles of wiring, it was certainly not going to become a human worker's desktop companion. Still, the machine's advances in electronically readable text and its sheer speed of operation -- capable of printing out 600 lines per minute -- meant that, in Beise's words, "80% of the time-consuming detail in servicing checking accounts" would be eliminated.

The machine's successful trial run in 1955 led Bank of America to contract with General Electric to build 32 more ERMA systems for use across the bank's 900 branches. By the mid-1960s, these systems processed 750 million checks per year, and the streamlining of Bank of America's check processing allowed it to roll out another pioneering financial innovation: the first credit card, which launched in 1958.

Automation spread rapidly throughout the financial industry, and in the 1960s it would begin to have a profound impact on the New York Stock Exchange . Throughout much of that decade, daily trading volume steadily nudged upward, from roughly 3 million shares per day at the outset to more than 10 million as the decade ended. By the end of the 1970s, trading volume consistently reached 30 million shares per day, and it has generally continued to increase ever since.

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