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Last week marked the end of an era on Wall Street. With the last two major independent investment banks, Morgan Stanley and Goldman Sachs, essentially converted to universal banks (investment banks joined with commercial banks), the age of the powerful, independent bank has ended. While the demise began with Bear Stearns’ collapse in March, the roots of the problem were inherent in the risky model of investment banking itself.

The investment banking model was built for boom periods. It was based on creating a “one-stop bank” for corporations — blending the issuance of debt with advice on acquisitions. In recent expansion, banks became a great place for corporations to get financial advice in exchange for hefty fees. Investment banks then parlayed these fees into greater profits using various risky financial products.

Of the five major investment banks existing at the beginning of the year, all have ceased to exist as pure investment banks, as their risky financial activity was funded purely by debt. Both Bear Stearns and Merrill Lynch leaped into the arms of opportunistic commercial banks, and Lehman Brothers went under weeks ago. The most significant development was Goldman Sachs and Morgan Stanley’s choice to start commercial bank arms. This vote of no confidence in the investment bank model allows the two to become universal banks. Universal banks like PNC or Wachovia take on deposits at local branches and ATMs, using that money to fund riskier investment banking activity.

The key difference is that universal banks are less leveraged — a fancy financial word for the amount of outstanding debt a bank has — because they’re grounded by Americans’ personal savings deposits. Goldman Sachs has a debt-to-equity ratio of about 22:1, meaning it borrows $22 for every $1 of capital it has. Morgan Stanley’s ratio is higher, at 30:1. Universal banks can boost their balance sheets by taking on deposits at local banks, like your checking account at PNC. In other words, Americans’ deposits fund riskier investment banking activity, which decreases the amount of debt universal banks have to take on.

The broader impact of the death of independent investment banks remains to be seen. It’s likely that increased competition in commercial banking will lead to better deals on deposit accounts for individuals. Moreover, the image of the investment banker, which has become glamorized, will also become less favorable. Universal banks can take on less risk, but also have a lower potential reward, which means that oversized Wall Street bonuses will decline. The death of the independent investment bank will reduce the number of credit swaps, collateralized debt obligations, and other risky financial products that have helped spread what was an isolated collapse in the subprime mortgage market to the broader economy. While no one knows for sure who is to blame for the current mess we’re in, the death of the investment bank is a part of the solution.

Tarun Bhan, H&SS 2009