Brokers Becoming Banks? The Press Got It Wrong

Yesterday, I received the below e-mail from Winthrop Brown, a friend of mine who is a very senior and distinguished banking lawyer at Milbank Tweed.  He was concerned about misreporting of the Goldman Sachs and Morgan Stanley conversions to bank holding companies and e-mailed me a clarifying analysis.

Apparently Win believes that it is important for the media to actually report real facts and analysis and not to pawn off “pop pundits” as authentic experts. I agree with my legal beagle buddy.

Set forth below is Win’s e-mail.

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Mark,

The following are some quick thoughts on the regulatory aspects of the announcement by Goldman Sachs and Morgan Stanley that they will change their regulatory status. They are intended to correct some of the misstatements in today’s press reports. Please feel to use this as research for your blog

• Goldman Sachs and Morgan Stanley are not converting to banks. The ultimate parent companies are becoming bank holding companies. Goldman Sachs and Morgan Stanley’s broker-dealer subsidiaries will have the same status as the broker-dealer subsidiaries of Citi and JPMorgan, or as Merrill’s broker-dealer subsidiary will have as a subsidiary of BoA.
• By virtue of conversion to bank holding company status, Goldman Sachs and Morgan Stanley will not have access to a retail deposit funding base. They will not themselves become depository institutions. They each have depository institution affiliates, which they say they will expand, but regulations strictly limit the extent to which these depository entities can lend to or otherwise fund the operations of their broker-dealer and investment banking affiliates.
• The broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley will not have access to the traditional discount window — only their depository banking affiliates will. The broker-dealer and investment banking subsidiaries of Goldman Sachs and Morgan Stanley will continue to have access to the Fed window on the special, temporary terms they did before the conversion but that access will not change as the result of their becoming bank holding companies. The Fed did expand the range of collateral that Goldman Sachs and Morgan Stanley could use in borrowing under the special access (as it did also for Merrill) but this was not a consequence of their change in status.
• The SEC will remain the primary regulator of Goldman Sachs and Morgan Stanley. The Fed will regulate the parent companies. The Gramm-Leach-Bliley Act of 1999 established the principle of “functional regulation” under which the Fed is supposed to keep its hands off the SEC-regulated operations of the investment banking subsidiaries of bank holding companies. The Fed has largely complied with this mandate.
• If the current banking affiliates of Goldman Sachs and Morgan Stanley are converted to national banks (as Morgan Stanley has announced it will), the Office of the Comptroller of the Currency will become the primary regulator of the subsidiary banks. The FDIC will have a relatively minor role in overseeing their operations. Neither will have any oversight over the broker-dealer affiliates of either company.
• The parent companies of Goldman Sachs and Morgan Stanley will become subject on a consolidated basis to the capital requirements that apply to bank holding companies. Goldman Sachs and Morgan Stanley were found by the Fed to have capital above the required level and the recent announcement of the Goldman/Berkshire Hathaway and the Morgan Stanley/Mitsubishi deals will further strengthen their capital position. Goldman Sachs and Morgan Stanley’s broker-dealer operations will continue to have to comply with the SEC’s net-capital rule on a stand-alone basis.
• The private equity operations of both companies will become subject to the so-called “merchant banking exemption” of the Bank Holding Company Act. The most important limitation of the exemption is that a portfolio investment may only be held for 10 (or, in some circumstances, 15) years. Other exceptions to the Bank Holding Company Act limit the extent to which the bank holding company may be involved in the management of its portfolio company. The two companies have two years to comply with these requirements. To the extent that the current private equity operations do not conform to these requirements after two years, the Fed is likely to give Goldman Sachs and Morgan Stanley additional time to comply.
• One can speculate about the extent to which these moves were pushed by the Treasury or the Fed. Goldman Sachs and Morgan Stanley could have applied to become bank holding companies under existing law at any time before the current crisis and their applications no doubt would have been approved. On the other hand, the applications were approved on a very expedited basis, suggesting cooperation from the Fed. The Fed is likely to have to grant waivers from its restrictions on affiliate transactions to the extent that Goldman Sachs and Morgan Stanley seek to move assets from their non-bank affiliates to the books of their bank affiliates; assurances that these waivers would be granted were undoubtedly given by the Fed.

Disclosure: Win has represented to me that he does not own any stock in Goldman Sachs or Morgan Stanley and I do not own any stock in either company.

Comments

[J Lauslega:]

Etudes in the integrated 1999 Congressional Acts associated with the Bank Holding Company Act seem otherwise notable if the politics is branched to sophisticated intolerances pre-considerate of caste obligation contractual variances noted at Sanarlega.net.

2008 Sep 29 04:25 PM

[peterrabbit:]

This is really confusing - I can't see ANY advantage to becoming a BHC. So why did they do it? All the reasons advanced by the press (use of deposits to set against investment banking operations for CAR reasons; permanent access to the Fed discount window) have been repudiated in your post. so we are left with a mystery. More work, please! :)

2008 Oct 01 01:40 AM