Goldman, M.Stanley transform into Fed-regulated banks

By Mark Felsenthal and Jessica Hall

WASHINGTON/PHILADELPHIA (Reuters) - Goldman Sachs and Morgan Stanley were granted approval on Sunday to become bank holding companies regulated by the U.S. Federal Reserve, effectively killing off the investment banking model that has dominated Wall Street for more than 20 years.

The move enables Goldman (GS.N) and Morgan Stanley (MS.N) to take deposits, gain easier access to financing and gives them more flexibility to buy retail banks. It was initiated by the only two big and independent U.S. investment banks left after the failure of Lehman Brothers (LEHMQ.PK) and the agreed takeover of Merrill Lynch MER.N last week.

The change, part of a wrenching transformation of the Wall Street landscape amid financial markets turmoil in the past two weeks, means that previously freewheeling firms will be subject to much tighter regulation by the Fed, including tough capital requirements.

That could curb their ability to leverage up their proprietary trading and other activity with mountains of borrowed money. This will reduce their chances of producing the kind of mega profits they had been making until the credit crisis started to hit home this year.

"The timing of this move, in conjunction with all of the other unprecedented steps taken in the past week, shows the seriousness with which the government and the banks themselves are still taking the short-term risks to systemic stability in the financial markets," said Kirby Daley, senior strategist at Newedge Group in Hong Kong. "The implications of all these measures taken together are mind-boggling."

Under the new set-up, the primary regulator of the parent companies switches to the Federal Reserve from the Securities and Exchange Commission but the SEC continues to regulate their U.S. securities businesses.

In exchange for the increased scrutiny, Goldman and Morgan gain long-term access to the Fed's discount window and access to bank deposits insured by the Federal Deposit Insurance Corp.

MORGAN, WACHOVIA MARRIAGE LESS LIKELY

Morgan Stanley is also now less interested in a merger with the banking group Wachovia Corp WB.N. That is no longer Morgan's first priority, though talks with other parties continue, a person familiar with negotiations said.

It held a board meeting over the weekend to discuss Wachovia and the possibility that China's sovereign wealth fund China Investment Corp could increase its stake in Morgan Stanley, according to sources familiar with the situation.

Morgan Stanley declined comment on the talks but it did say in a statement that the new status would give it "flexibility and stability to pursue new business opportunities."

"In some ways this makes it easier for them to buy a retail bank, but they may argue that this makes them self-sufficient and they don't need to buy a bank now," said the head of global mergers at a U.S. investment bank.

"But they can't raise deposits fast enough organically to stabilize their problems, it has to come through M&A," said the banker, who declined to be identified because he was not authorized to speak with the media.

Goldman intends expanding its deposit base by acquiring deposits wholesale from other banks, particularly those in distress, said the firm's spokesman Lucas van Praag.

It began to feel that it needed to consider something like Sunday's move after the government-financed fire sale of another investment bank, Bear Stearns, to JPMorgan Chase & Co (JPM.N) in March, and the events of the past week accelerated this thinking, he said.