PAGE 42 THE STERN STEWART INSTITUTE PERIODICAL #10 JAMES GORMAN: NAVIGATING THE CHANGING LANDSCAPE OF FINANCE

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1 PAGE 42 THE STERN STEWART INSTITUTE PERIODICAL #10

2 THE AUTHOR James Gorman Chairman of the Board and Chief Executive Officer Morgan Stanley PAGE 43 Navigating the Changing Landscape of Finance Contrary to the popular perception, the fundamental problem with US banks had almost nothing to do with their size, or their complexity. It was in fact the smallest of the large US financial institutions that got into the most trouble while the largest, JPMorgan Chase, saw the least destruction of value during the crisis. Complexity itself was not the culprit either. Some complex banks managed their risks effectively, while many conventional deposittakers and lenders failed, reflecting significant differences in the quality and judgment of management. The response of the US government to the crisis, mainly in the form of Troubled Asset Relief Program (TARP), proved highly effective in limiting the damage to banks and the global economy. And to reduce the probability of a future banking crisis, US regulators are now well along in implementing a new three-part regulatory model. Thanks to such regulatory changes, and to the response of most financial institutions to them, the US financial system has been restored to stability. Let's start by looking back and trying to understand what happened. My simplistic explanation is that bank balance sheets became over-levered with more and more illiquid risky assets. As time went by and it became apparent that some of those assets were problematic as well as risky and illiquid, banks started taking losses to their capital. Their capital bases were already pretty thin to begin with, since in most cases they were operating with leverage of about 30 times. Therefore, it didn't take investors and creditors very long to figure out that banks' over-levered balance sheets had exposed them to the risk of running out of capital and going out of business. And it was that concentration of losses to capital in already overleveraged institutions that created a crisis of confidence. Banks are conduits. They don't keep most of the cash their depositors give them. Therefore, when there's a crisis of confidence and everyone wants their money, you have a liquidity problem. And if the crisis of confidence becomes deep enough, you get a good old-fashioned run on the bank. Once you've had a run on one bank, people start looking around and saying, Well, how good are the other banks?

3 PAGE 44 THE STERN STEWART INSTITUTE PERIODICAL #10 Eventually, the crisis hit every financial institution. Anyone who says that this crisis didn't affect them has a fundamental lack of understanding of what a liquidity crisis is. It affects the whole system and, ultimately, it undermined confidence in the US financial system and everything that we stand for. Interestingly, such failures and restructurings did not happen in certain other heavily banked markets with very large banks, notably Canada and Australia. Although I won't go into the whys and wherefores, the success of these other banking systems in weathering the crisis raises a fundamental question: Did our system nearly fail because our banks are too big? My sense is that the crisis had almost nothing to do with the size of US banks. It was actually the smallest of the large US financial institutions that got into the most trouble. Among the biggest US banks, it was in fact the largest JPMorgan Chase that saw the least destruction of value during the crisis. And as someone pointed out to me, Chase's balance sheet is by no means the world's largest; in fact, it ranks eighth and it's the only US institution in the world's top ten. So, again, I don't see the size of our banks as the culprit. For historical reasons, the US has the most fragmented banking system in the world. In the mid-1980s, we had over 15,000 banks; and though their numbers keep coming down, we still have 7,000 banks the vast majority of them are quite small. On the other hand, I think there were a lot of institutions that had not properly grown up from their days as Wall Street partnerships, when their capital was their own money. When these partnerships suddenly became public companies and I think DLJ was the first to go public, and then Merrill Lynch they didn't necessarily put in place all the gates that you would if you were a true public company. They continued to rely on aspects of the partnership model, but in a public company spectrum with much larger balance sheets and little if any of their own capital at risk; it was now somebody else's capital. In some important ways, the Wall Street fraternity had not grown up quickly enough with the size of their institutions, particularly in terms of developing risk management processes and controls. And there were some other kinds of bad management decisions. For example, some failed institutions passed up opportunities to act preemptively by selling off assets at maybe not the optimal prices, or the prices they wanted, but at prices that would have saved them. Therefore, don't underestimate the ability of management to really screw things up. Taking all this into consideration, there was no single culprit in this crisis; there were many contributing factors. However, at the core of the problem was what I aforementioned: When you use very high leverage on very thin capital bases to acquire risky and illiquid assets, then if any shock hits the system you've got a problem. The smaller and more concentrated you are, the bigger the problem that you have got. Regulators have put in place a new set of protectors, or preventive measures, at the front end. At the same time, they have put in a back end that is meant to deal with the possibility of financial trouble. They have said to the banks, Let's assume our new capital and liquidity requirements aren't completely effective, and we have to unwind an institution or put it in a bankruptcy or resolve it by selling off pieces. Do we have a process for doing that? Do we know what all the legal entities are globally? How do we run that very complicated set of legal entities through a machine that helps us sell them off, unwind them, and effectively put them into bankruptcy? These are important questions because, as we saw in the case of Lehman Brothers, there was a major problem, particularly in the UK, in releasing capital that was trapped on its balance sheet.

4 THE STERN STEWART INSTITUTE PERIODICAL #10 PAGE 45 Therefore, regulatory response at the back end has taken the form of a resolution plan for banks. The plan has been put together by the Federal Deposit Insurance Corporation (FDIC) in collaboration with the Bank of England and our Federal Reserve. The regulators have told the banks, We will walk into your institutions and if those gates that you put up at the front don't work and the bad stuff is happening, here's how those problems will get resolved. Here's how any problems at Morgan Stanley will get worked out. The government and the regulators have put in place new front-end requirements that are designed to keep banks from getting into financial trouble. Moreover, they have developed a plan to deal with any cases where the new requirements fail to keep institutions out of trouble. And in the meantime in between these front and back bookends, if you will all large banks also get a report card once a year from the Federals Reserve known as a CCAR (Comprehensive Capital Analysis and Review) that requires the banks to put their businesses and balance sheets through stress tests that are worse than the financial crisis we just went through. The point of these tests is to see if banks would survive a theoretical set of scenarios, with survival defined as a capital ratio that never falls below five percent. Therefore, the new regulatory regime consists of three main phases and sets of requirements. At the front end, you have some blunt instruments that say that banks have got to have more capital, more liquidity, and less leverage. The back end says that if this thing doesn't work for some

5 PAGE 46 THE STERN STEWART INSTITUTE PERIODICAL #10 banks, there's a way to unwind them. And in the middle, we have annual report cards that give each bank a score. That score dictates whether the bank can do buybacks, acquisitions, or pay dividends or whether it has to raise more capital instead. And that three-part regulatory model is now starting to be rolled out globally. When evaluating the government's overall response to the crisis, let's not forget the effect of its actions on US taxpayers. By that I mean TARP, the money that was given partly to banks to recapitalize them to the point where they could go out and raise their own capital. First of all, most people seem to have forgotten that most of the $700 billion did not go to banks. The amount that went to the banks was about $245 billion; the rest went to govern-ment-sponsored enterprises (GSEs) like Fannie and Freddie, insurance companies, auto manufacturers, and so on. And the big banks all paid back TARP, as they should have; that was their responsibility. And the banks ended up providing taxpayers with a high return on investment in the form of interest payments and warrants. In the case of Morgan Stanley, the return to taxpayers was 21%. We like to think we did some of these things before our regulators told us to do them because we were sufficiently introspective or self-aware to know that we had to make the changes. For example, we didn't need someone to tell us that we were undercapitalized, and so we went out and raised a lot of capital. As a result, we now have two very large investors: China Investment Corporation (CIC), which is the sovereign wealth fund of China; and Mitsubishi UFJ Financial Group, the largest Japanese bank that now owns 22% of Morgan Stanley in a unique global partnership. So we've created strength and stability at the front end. Our liquidity at the time of the crisis was about $80 billion on a balance sheet of $1.25 trillion. It's now about $180 billion on a balance sheet of about $800 billion. Our leverage at the time was about 35 times; it's now about 12 times. Our capital was $30 billion; it's now $62 billion. Encouragingly, we've gotten high enough marks on our annual CCAR that we have been given permission by the regulators to do two things: One is to commence a stock buyback program, which we've done very modestly. Second, we completed our acquisition of a wealth management business that we've been working to buy in a complicated deal with Citigroup over the last four or five years. As a result of this acquisition, we are now one of the world's largest wealth managers, which gives us balance and stability. However, at Morgan Stanley, we probably made more fundamental and important strategic changes in the past two years than I saw those institutions as a group accomplish in over two decades. The most important part of my message is not about Morgan Stanley. The real story is that the US financial system is now, I believe, safe and sound. If the industry is to make an effective response, it seems clear to me that the response has to address the question: Why do banks matter? The answer has to begin with the basic function of the industry, which is to mobilize capital. You can't take capital out of capitalism. We as a society need banks to match savers and borrowers, investors with money to invest and companies that need capital. Providing hundreds of billions of dollars to today's large multinationals is just not going to happen with a bunch of small banks. And in terms of meeting global competition, US banks, for all their recent failings, have continued to succeed in if dominate is not the right word a number of important categories of financial products and services. Why we would want to cede that competitive edge to other nations in the name of smaller banks makes no sense to me. There is no compelling argument no theory or body of evidence that says that our financial institutions are too big. The full article was published in the Journal of Applied Corporate Finance, Vol. 25

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